How To Place Calendar Option Spreads

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Calendar option spreads: Tonight, we’re going to go over all of the trades that we made for Monday, November 24th. To kick off the short trading week, as a reminder, and I mentioned this last night on the strategy call for premium members, but this week, the markets are closed on Thursday for Turkey Day, and then on Friday, they close early at 1 PM and I think the bond market closes a little bit after 1 PM, so just make sure that you're aware of that in case you’re going to place any trades on Friday.

I don't think that we’ll be too active on Friday with the markets being closed and short closed on Friday. But if we do, we’ll place any trades before 1 o’clock. Today, we have three new trades to go over, all of them are low probability, low implied volatility type trades, not saying that they're going to be losers or winners or whatever, but these aren’t the trades that are bread-and-butter trades. And this is basically what the market gives us at this point, so we’ve got to trade what we can trade and what’s available.

A lot of the implied volatility that was on the market about a month ago is of course completely gone, so now what we have to resort to is being a little bit picky-choosy on some of our directional put spreads, so that would be things like the J&J or Johnson & Johnson debit vertical put spread, and then also trading some calendars because calendars can take advantage of a rise in implied volatility, so they’re great when implied volatility is low. And we traded some of them in Wal-Mart and then UNP today, so we’ll go over those in total.

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calendar option spreads

Let’s start off here with Wal-Mart. Remember, with these calendars, Wal-Mart and UNP are very much the same things except a little bit of difference on price and strategy in what we did here, so we’ll go over that in a little bit more detail. But remember that with these calendar spreads, you are buying the back month which is January, so we’re buying January, that's further out a month, and you're selling that front month option which is December.

We want to be sure that when you place that order, it is a buy order and you do have a debit to place that order because those back month January options are more than what you’re selling the front month December options for. Those front-month options are there to reduce the cost of the whole strategy, and you want to make sure that there’s some premium in those December options before you just go ahead and sell anything in December because you’re going to use that money to reduce the cost of those January options that you’re long.

Now with Wal-Mart, we did the 85 puts for about $50. We ended up doing two of those and put ourselves into a position where it’s just about a $100 bet. This is a tiny percentage of our portfolio, but it’s a means to stay active and to take what the market gives us as far as possible opportunities.

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Here's the chart here of Wal-Mart as it’s loading up. Apparently, what you'll notice about Wal-Mart is that it’s had a huge, huge run-up since the lows at the end of October. We know that at some point, Wal-Mart could continue to move higher, that's not a question, but all we’re doing here is playing the probabilities and the likelihood that we might get a move back down in Wal-Mart sometime between now and expiration in December.

Now that all said, Wal-Mart did have good earnings, so we’re playing this one a little bit different than UNP. In that, we’re playing our strikes a lot closer to the money. We’ll go here, and you guys can see where our position is in Wal-Mart. We’re up already $11 on the day which is nothing. But with our short strikes, we went ahead and did our short strikes very close to the money with Wal-Mart, did the 85 strikes on either end.

You can see that we looked out to January which is out here and we had to choose one of these two strikes because we can’t do the 84s. Those are out of the question; those aren’t even anywhere in January. You can’t do a calendar at 84, you can’t do a calendar at 86, so you’ve got to either go with 85 or 82.5. Now, in this case, the 82.5s just didn't have a lot of premium, so they were only worth about $37.

Now remember, with calendar spreads, since we’re selling that front month, that's ideally what we are targeting as our profit, that’s what our guidepost should be, is to how much we should make on this trade, is about $.37 if we did the 82.50. Now, in this case, the 85s are trading for about 116. Now, we can’t make a great 116 trade, but that's a lot more premium, there’s a lot more in that that can decay in value if Wal-Mart just sits here or even threads water in an excellent little-defined range.

That’s why we decided to go with the 85s. It also just had a little more activity overall than the 82.5. Now, when we look at the actual analyze tab here and we look at the risk profile of Wal-Mart, let me just pull it up for you guys, you can see it’s got that nice pyramid-shaped profit loss diagram all centered over 85. But what I like about it is it’s got such a wide base.

It did cost a little bit more to get into this calendar, but it’s got such a wide base, it’s got a breakeven on the bottom side of about 82.5, and on the topside, about 87.5, so a huge, huge range for Wal-Mart to trade in. You can see it's got to trade between basically 87.5 which is up here and about 82.5 which is up here. This is our money range. And in low volatility environments, it acts very similar breakeven wise as an iron condor, it’s just we’re not selling premium. We’re going to be a net buyer of premium with implied volatility as low as it is. That’s the setup in the Wal-Mart trade.

For UNP, we did something very similar except we went a little bit further out of the money and did the 120 strikes. Now, there’s a particular reason why we did those strikes and I’ll show you guys here in a second. Here's the chart of UNP just to show you what the stock looked like heading into this trade, very similar type of action as Wal-Mart. We’re anticipating that at some point, it’s going to maybe settle around 120 or just start to head in that direction.

The markets have been really, really hot, that doesn’t mean it can’t continue higher, we’re just maybe a little bit of a selloff and playing a little bit of the downside nature of this chart here. When we look at the analyze tab on UNP, you'll notice that our position is a little bit to the left of where the stock is trading now. UNP is trading right here about 123 and the center of our strategy is right here over 120. We did play this one a little bit more to the bearish side and you can see that that’s where we make the most of our money.

Now, there’s a reason we did this and the reason is because the actual 120 strikes were really the only strikes that were active for UNP in that whole entire area in the December options. You can see the December options are here, the 120 strikes are right here, and notice they’re the only strikes that have both activity in volume and open interest. Now, the bid ask spread is a little wide, but we only did one contract, so that's okay, we’re not really getting killed on that.

But you'll notice that that's really why we did the 120s versus the 121 or the 123 because they were the only ones that had a lot of activity, plus if you go out to January, there is no 121s, no 123s, all you have is $5 wide strikes in January, so you basically had to choose the 125, the 120 or the 115. Those were the only strikes that were really available.

And you can see that the market just basically removes themselves from the rest of the strikes. Nobody is trading these except for maybe a couple of guys trade who were trading them long or short or whatever the case is. That's the trade that we made in UNP.

Johnson & Johnson was a little bit different. Because already had some calendar spreads, we decided that we could add some debit put vertical spreads, so playing the market directionally. In J&J, we did the December 108/106, so a $2 wide spread and we did it for just about mid-price which is ideally what we want to do at $.95. That puts our breakeven very close to 107 in J&J. Now, J&J has had obviously a huge move up and has started to already turn over.

One of the kind of I guess not deciding factors, but something that lead us to believe possibly that we could see a nice little roll over in the stock and continued move higher, is we did happen to glance the technical's which I will do on occasion with these trades, and we noticed that it did have a nice bearish cross on MACD which is an early signal for this.

And going back historically, it’s been a pretty good signal for Johnson & Johnson a couple of times before in the past. You can see back in July, it had that signal here which lead to the selloff that happened over the next month, in September, it had the signal here, lead to the selloff that happened September through October. And hopefully, we’re assuming that this signal will lead to another little mini selloff here as we head into December.

Now with this trade, because our breakeven is only at 107, all we need is for the stock at some point to trade below 107. It’s just got to trade below 107 which is right above here, so right above where it’s trading right now. It’s got to trade just at some point during the expiration cycle below this level and we’ll have an opportunity to take some money off the table. I really like this trade.

I don’t want to get too many trades like this, but there’s a lot of things out there that are shaping up very much the same way. I think Johnson & Johnson is one of the first ones to start heading over and it’s obviously a big-name, big securities company and stock to be a leading indicator. But I think generally, financials are looking and shaping up about the same way, they’re just slowly losing steam and starting to roll over, so it'll be interesting to see how this all plans out for the rest of the week.

But for today, we just wanted to enter a couple of few small trades that help keep us active in the market with low implied volatility. As always, if you guys have any comments or questions, please ask them right below. I’ll get back to all of those tonight or tomorrow before the open. And if you’re watching this video somewhere else online or on YouTube, you just have to understand that you're getting these alerts and this video about 15 days after they're sent out to our members.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.