Lesson Overview

Put Calendar Spread

Long put calendar spreads profit from a slightly lower move down in the underlying stock in a given range. They also profit from a rise in implied volatility and are therefore a low-cost way of taking advantage of low implied volatility options. Calendar spreads lose if the underlying moves too far in either direction. The maximum loss is the debit paid, up until the option you sold expires. After that, you are long an option and your further risk is the entire value of that option. Options in nearer-month expirations have more time decay than later months (they have a higher theta). The calendar spread profits from this difference in decay rates. This trade is best used when implied volatility is low and when there is implied volatility "skew" between the months used, specifically when the near-month sold has a higher implied volatility than the later-month bought.

Show Video Transcript +

In this video tutorial, I want to talk about how you would go about adding or trading a put calendar spread. Remember that long put calendar spreads profit from a slightly lower move down in the underlying stock inside of a given range and they also profit from a rise in the implied volatility and therefore are a low-cost way of taking advantage of low implied volatility options and markets.

If you download our strategy guide that we have inside of our membership area at optionalpha.com, you know that we’re big fans of calendars when implied volatility is very, very low. That's the key here. They got to be low implied volatility, and you can use these calendars to get a little bit directional in your trading.

How do we setup this trade? The first thing that we’re going to do is we're going to sell the front month out of the money put option. Front-month options, we typically target anywhere between 20 and 45 days or so, maybe around 30 days.

That’s the example that we’ll be going over today in this video. The next thing that you’re going to do is you’re going to buy a back month option, so the next monthly contract out and you’re going to buy an out of the money put at the same strike price.

We’re trying to hyper focus here on the differential between the contract months, not so much the difference between the strike prices. You got to trade these at the same strike price.

What’s the risk? Your risk is limited to the width of the net debit paid for the spread. If you paid a debit of $1.50 for the calendar, your risk is just limited to $1.50. It’s a very low-cost way to trade options.

Profit potential can vary with these strategies because of the decay in the back month option that you’re long, so ideally, you are looking to target your profit at the value of the sold front contracts.

If you sold the front contract for somewhere around $.30 or $.50, maybe that’s what you might be looking to get as far as premium on the spread that you bought. Profit potential is maximized if the stock settles at the strike price at the front-month expiration.

That’s where our profit loss diagram to the left of the screen really peaks out, is if the stock settles right at our strike prices because our front month contract would expire completely worthless (remember that we sold that front month contract) and our back month contract that we bought is going to have still some value left because it still has some time until it expires in the next contract month.

As far as volatility goes, these positions have a positive impact when implied volatility is increasing. Volatility tends to show a greater boost in the value of the back month option that we’re long because it has more days compared to the negative impacts of the front month option that we’re short.

Try to take advantage of these two different contract months. Increasing volatility or Vega is going to have a really big impact on our position especially in that back month option that we’re long.

That's why you have to trade these from a low implied volatility market to a rising implied volatility market. As far as time decay is concerned, the passage of time will help this position.

Since we're looking to collect the value of the front month option, the closer we get to expiration, the faster a profit will materialize and the quicker that we're going to see this profit loss diagram start to mold and shape.

As far as breakeven points, they’re a little bit harder to calculate with calendars because there’s no single way to determine them. I always say that it’s important that you analyze a trade first before you place an order.

We’re going to do that here right on our broker platform in Thinkorswim. We have a trade tab up here of SPY and SPY is currently trading right now around 202.50 or so. If we’re directionally bearish on this stock, we might go down maybe one or two strikes out of the money.

That's typically how we like to trade these. I might go down to say the 201 strike which is about a strike and a half out of the money from where the stock is trading right now. We’re going to be just a little bit directionally bearish, and we’re going to hope for an increase in implied volatility.

When it comes to placing this trade, the first thing that we’re going to do is we're going to sell that front month option at 201. I’m going to just click on the bid here, we’re going to sell that front month option at 201 and then we’re going to go over to the back month option which is March, and we’re going to buy that option.

Notice the front month options have about 30 days to go, these are the February's, the back month options which are March have about 57 days to go, so we’re selling the 201s in February, buying the same strike price at 201 in March.

One little quick thing here is that you'll notice when you do these calendars, sometimes the front-month contracts have strike prices that you don't see in the back month.

In this case, the back month doesn't have the strike price 201.50, so you want to make sure that you're doing strike prices that are the same in both contract months.

This calendar spread here cost us a debit of 174, so it’s a little bit more expensive than we usually like to pay. We like to pay around $125, $140 or so for a calendar spread, but a little bit more expensive gives us a little bit more premium to work with.

As far as the profit loss diagram, though, it’s very, very attractive for this calendar. You can see this is that peak that we see in the profit loss diagram from the slides before. This is where the stock ideally should try to pin at expiration which is around 201 as far as a price.

The stock is trading right here. This is the dotted line on the graph. This is where the stock is trading, about 202.5. You can see we’re just a little bit directionally bearish on this trade, so we need the stock to move down just a little bit to make some money on this trade.

But what's great about this calendar is that our breakeven points are about 206.5 to 195.5, so we’ve got a very wide window to make money on this trade which is great.

Even though it cost us a lot of money upfront, about $174 to enter this trade, we’ve got a very wide window of opportunity to make some money.

As far as key takeaways go, these are low implied volatility strategies that work best when you’re using strike prices one to two levels out of the money in the direction that you want to trade.

The further you get with your strike prices as you get further and further out of the money, the more and more directional this trade becomes. It's important that you keep these strike prices just a couple of levels out of the money to maximize the potential of the strategy.

We suggest closing the spread completely at front month expiration whenever possible. This means that you close out the trade when you get to that front month expiration.

In the example we just went through, that would be February expiration, about 28 days from now, so you want to close out the strategy regardless of what happens at February expiration. You’re not going to carry it all the way through to March expiration.

As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below in the video lesson page. Until next time, happy trading!

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