How To Trade The Calendar Spread for Income

A calendar spread, which is often referred to as a time spread, is the buying and selling of a call option or the buying and selling of a put option of the same strike price but different expiration months.  In essence, you are selling a short-dated option and buying a longer-dated option.  This means that the result is a net debit to the account.  In fact, the sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright.  Because the two options expire in different months, this trade can take on many different forms as expiration months pass.

There are two types of long calendar spreads: call and put.  There are inherent advantages to trading a put calendar over a call calendar, but both are readily acceptable trades.  Whether you use calls or puts depends on your sentiment of the underlying investment vehicle.  If you are bullish, you would buy a calendar call spread.  If you are bearish, you would buy a calendar put spread.

A long calendar spread is a good strategy to use when you expect prices to expire at the value of the strike price you are trading at the expiry of the front-month option.  This strategy is ideal for a trader whose short-term sentiment is neutral.  Ideally, the short-dated option will expire out of the money.  Once this happens, the trader is left with a long option position.

If the trader still has a neutral forecast, he or she can choose to sell another option against the long position, legging into another spread.  On the other hand, if the trader now feels the stock will start to move in the direction of the longer-term forecast, he or she can leave the long position in play and reap the benefits of having unlimited profit potential.

How to Find Calendar Spread Candidates

 • Check the current value of implied volatility (IV) and the history of IV over the past three to six months (free at ivolatlity.com).  Be sure the current IV is in the bottom quartile of recent IV history.

• Don’t trade a negative IV skew (if ≤ 2 points, maybe… but doubtful).

• Investigate very carefully if the positive IV skew is ≥ 4 points (suggests a big move is expected).

• Calculate the standard deviation (σ) for the candidate stock; use current IV and number of days to expiration of the front month option; look at the price range (lowest to highest) of the past week and the past month; avoid this stock if the recent price ranges are > 1 σ.

• Be sure no earnings announcements or other significant announcements are pending during the course of the proposed trade.

• Be sure you are selling > $0.40 of option premium (otherwise, commissions eat up too much of your profit).

• Calculate the breakevens (BE) using your trading software; you want a broad range between the BEs.

• Low IV stocks (12–‐20%) are conservative but require a large number of contracts; consider the effect of commissions.  Stocks with higher IVs (≥ 20%) present more price movement risk but have large premiums

Managing the Trade – Making Trade Adjustments

 • When you have traded calendar spreads for at least 6 months, you may consider adjustments. Until then, simply close the trade when the stock price hits a BE or the trade hits the stop loss you established. 

• Use the BEs or a price just beyond the BEs as your trigger.

• Close a portion of your contracts and place another calendar at or near the new price; determine the number of contracts to close and roll up or down by the number it takes to move your position delta back closer to zero.

• For example, IBM is at $172 and we put on 10 contracts of a $175 call calendar. IBM moves to $176 (our upper BE); we close 4 of our $175 calendars and open 4 $180 call calendars.  If we think IBM may move even higher, we might place the new spreads at $185.

• Don’t adjust a trade if you have < 15 days left to expiration (unless you have multiple months, e.g., you have a Jun Sep $175 call calendar; we close some or all of our Jun $175 calls, and wish to roll up to $180 but we only have 8 days to expiration; then you would sell the July $180 calls).

• Manage the new calendar spread just like the original trade (write down your management criteria).

In summary, it is important to remember that a long calendar spread is a neutral – and in some instances a directional – trading strategy that is used when a trader expects a gradual or sideways movement in the short term and has more direction bias over the life of the longer-dated option.   This trade is constructed by selling a short-dated option and buying a longer-dated option, resulting in a net debit.  This spread can be created with either calls or puts, and therefore can be a bullish or bearish strategy.  The trader wants to see the short-dated option decay at a faster rate than the longer-dated option.  The time decay is your income just like it is in the covered call trade.

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