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Calendar Spread Strategy - Page 2

Analyzing risk/reward

Understanding the risk of a calendar spread is the easiest part of this process since the most I can lose in a calendar spread is the initial debit when I open the trade.

Calculating the reward can be a bit of a difficult process since the reward depends on so many factors. With this strategy, it is important to realize there is no way to arrive an an absolute maximum gain. The best way to approach this is to try a couple of sample scenarios.

Calendar Spread: OIC Position Simulator

Fortunately, the Options Industry Council (OIC) provides a nice simulation tool for guesstimating future value of a close or a roll (Thinkorswim also has a nice analysis tool for this but I'll stick with the OIC tool for now).

What I've done is enter in my position as a March short 28 put and an April long 28 put purchased with the underlying at $30. Then, using the simulator, I've projected forward what the value of the spread will be worth 5 days before expiration and the underlying still at $30. The projected initial cost of the position is $.47 or $47 for 1 contract. The projected profit with the above parameters is $23, which is a 48% return on the initial investment.

I prefer to look at a less than ideal outcome because the chances of any underlying landing right at the chosen strike is not that high. So I'm essentially estimating whether I can make any money on this trade if the price stays about where it is ($2 away from my short strike) and 3 weeks passes by.

If I am contemplating a multi-month calendar spread, I can still use this simulator to estimate the return. I can select a later month for the long position, which will cause the simulator to show a higher initial starting price. The problem is that it is difficult to calculate the roll value.

When I did this on the simulator (changing the long Apr 28 put to a long May 28 put), the initial price increased to $88. That makes the per month cost $44 since I am now doing a 2 month spread. Remember that the value of the initial March/April spread with 5 days to expiration is $23. I can now do a new ROI calculation using the lower per month cost as my basis, which yields an ROI of 52%.

When I'm researching a calendar spread, I usually look at both the 1 month and 2 month spreads. I will typically go with a longer spread when my projected ROI will be higher.

By the way... the thinkorswim platform also has some nifty capabilities for analyzing calendar spreads and projecting future roll values.

Placing the order

When position sizing for this type of trade, I always use my maximum loss to determine the number of contracts to trade. It is rare that I loose the full cost of the calendar spread simply because of the way it is constructed, but I have had it happen a few times. I'll discuss some early exit signs in 'trade exits' to help preserve some of the value in the trade.

In considering the above trade, the cost to enter the trade is $.47 and I was willing to risk $1000 on this trade, I could calculate my position size as: $1000/(.47*100) = 21 contracts.

Many brokers require approval for level 3 trading authority, which allows right to trade spreads. Before you begin trading spreads, you may want to check with your broker to make sure you are approved.

Most options brokers support placing this order simultaneously. While you can place this as two separate orders, I don't recommend it. Too much can happen between the two orders that affect the net credit you receive.

Some online brokers designate opening orders differently than closing orders. Let's say using the above chart, I want to sell the March 28 put and simultaneously buy the May 28 put. I might place the combination spread order as 'buy to open 1 contract of the May QQQQ 28 put and simultaneously sell to open 1 contract of the March QQQQ 28 put for a net debit of $.88'. With this combination order, either both get filled or neither get filled.

Trade Exit

To realize a profit, I will have to place some kind of closing trade. In the most ideal case, my QQQQ March 28 put expires near 28 but worthless leaving me long a May 28 put. I could probably close the trade with a profit and be done, or I could sell the April 28 put, creating a 1 month calendar.

Realistically, I won't wait for the option to expire. From a trade management perspective, here are what I monitor for.

  • With about 4-7 days or so until expiration, I'll look to either close the trade if it is a 1 month spread or roll to the next month if it is a longer term spread. However, if I can close the trade with about 30-40% return immediately, I often will.
  • Depending on the direction the stock is heading, I may wait and get closer to expiration for a more optimum price.
  • If I see too much deviation from the range I projected, I'll typically just close the trade for whatever small loss (or even sometimes gain) I can get. This is a pretty subjective measure, however, if a stock breaks a support or resistance level, it usually means the sideways movement is through and now my projected outcome is uncertain.

Some brokers require you to specify the type of order being placed (opening or closing) so it is important to realize what is going on with the two legs of the calendar spread. If I want to close my position completely, I may specify the order as 'buy to close QQQQ March 28 put, sell to close QQQQ May 28 put for a net credit of $...'.

If I am rolling my position from March to April, I may have to specify the order as 'buy to close QQQQ March 28 put, sell to OPEN QQQQ April 28 put for a credit of $...'.

Summary

The calendar spread is a more complex strategy than many of the those I've discussed. However, it makes a nice compliment to a my overall trades. While it is complex, it can also be a really nice income generator. It also compliments other positions, such as the short vertical spread because it actually benefits from volatility.

Notice that as I've discussed the various steps to trading the calendar spread, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system I follow. This is a critical aspect of successful options trading. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.

Note: Be sure to check out the Calendar Spread Tutorials on my Youtube channel.

Outlook: Medium term bullish to neutral (call calendar) - Medium term bearish to neutral (put calendar)
Max profit: Difficult to calculate
Max Loss: Initial debit of the spread
Net Position: Neutral - not really long or short
Time decay effect:  Works in your favor
Volatility effect: Benefits from an increase in volatility

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