How to Trade Calendar Spreads – The Complete Guide

This is your complete guide to calendar spreads. In this episode, I walk through setting up and building calendar spreads, the impact of implied volatility and time decay, how to adjust and exit, and the best market setups for these low IV option strategies.
How to Trade Calendar Spreads – The Complete Guide
Kirk Du Plessis
Jan 16, 2017

Today's podcast is all about learning how to trade calendar spreads. And while newbie traders might find them a little difficult to understand conceptually at first, I think you'll find our talk today to be incredibly helpful as we break down these time spreads from start to finish.

Key Points from Today's Show:

  • A calendar spread takes advantage of the pricing differential that may start to develop between a front month option and a back month option.
  • Most calendar spreads are set up to have a one-month differential.

Setting Up a Calendar Spread

  • To set up, first sell the front month option and then buy the same strike price and contract back month option for the next month. For example, you might sell the 50 strike puts in January, and then buy the 50 strike puts in February or March.
  • This takes advantage only in the difference in time between the two monthly contracts.
  • The key is to use the exact same strike price and the exact same type of option.
  • When scanning for great calendar spread trades, look for low IV rank like we found using our Watch List Software.

Price of a Calendar Spread

  • The price that you pay for a calendar spread is the difference between selling the front month and buying the back month contract.
  • This debit that you pay becomes your max loss at the first expiration date.

Example:

The USO ETF trades at $11.72. Looking at the January-February call calendar in USO, the January strike calls are trading for $16-$17. The exact same 12 strike calls in February are trading for $34-$36. To create a new call calendar spread for USO, sell January's calls, collect a premium of $16-$17 and then buy the back-month calls -- February calls. The next debit will be ~$20. This is your max loss for the January expiration date.

Once you get to the January expiration, those February options may still have value that could be lost if you go past the January expiration. Therefore most calendars are managed in the front month expiration.

Calendar Spread Potential Profit

  • Potential profit is hard to peg on calendars because it depends on the difference between the strike prices as you get towards expiration.
  • Calendars are only concerned with extrinsic value in the different contract months -- time value and volatility value.
  • Intrinsic value is always the same and directly offset from one contract to another because you are trading the exact same strike in opposite directions.
  • Maximum potential profit will be achieved if the stock lands at your strike price, at front month expiration.
  • The payoff diagram can expand or contract with volatility as you get closer to expiration. Example of simulated higher implied volatility is below.

When Are Calendars Best Used?

  • Calendar spreads can be used in any direction — bullish, bearish, or neutral around the stock.
  • Backtesting shows the best success comes when you are either slightly bullish or slightly bearish on the stock.
  • To balance your portfolio, can use a calendar spread to trade in the direction of where you need your portfolio to move.
  • Calendar spreads are best suited during periods of low to high volatility.
  • During periods of high volatility, option prices are going to expand and time decay will be less on the back month contracts that you are long.

Adjusting Calendar Spreads

  • Calendar spreads are usually very cheap positions that do not need as much adjustment.
  • If a trade is going in the opposite direction of where you think it is going to go, roll your short strike as the market is moving.
  • With a put calendar spread, if the stock price increases, roll up your puts to move in the direction of the market.
  • Another adjustment strategy is to add another position, creating a double calendar spread — not a preferred strategy.

Example:

For the 12 strike call calendar spread for USO stock, if USO price falls, roll down the short 12 calls for a credit which helps reduce the cost of the calendar spread and transfers some of the risk, shifting your payoff diagram lower.

Exiting and Closing Out Calendar Spreads

  • Sell the back month option, buy back your front month option, and close the position for a higher price.
  • If you reach expiration and the stock has not moved as well as expected and your options are both out of the money, can let your front month option expire and keep the back month option as a lottery ticket for the next 30 days.

Example:

Assumed USO would move up to 12 strikes for call calendar, but USO stayed lower all the way through the expiration cycle. Will still get some benefit from the January decay in the options, but when you reach January expiration, could choose to leave the 12 calls long for February. These act as lottery tickets for February, hoping that USO price moves higher.

*Remember to check the value at January expiration.

Example:

If the USO 12 call for February is still worth $35, if you leave it on you could still lose an additional $35 because that is now a new value that could be lost after the January front month expiration. The best time to leave these on as lottery tickets is if they are worth a really small amount.

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