They can use ATM (At The Money) strikes which make the trade neutral. If using OTM (Out Of The Money) or ITM (In The Money) strikes, the trade becomes directionally biased.
The maximum gain is realized if the stock is near the strike at expiration of the short option. If this happens, the short options will expire worthless but the long option will still have value. How much value? Depends on IV (Implied Volatility) at that moment.
How the calendar spread makes money?
The first way is the theta (time decay). The idea is that the near term option is losing value much faster than the back month option. Sounds good, doesn't it? The problem is that the stock will not always act according to our plan. If the stock makes a significant move, the trade will start losing money. Why? Because if the stock moves up significantly, both options will have very little time value and the spread will shrink.
The second way a Calendar Trade makes money is with an increase in Implied Volatility in the far month option or a decrease in the volatility in the short term option. If there is a rise in volatility, the option will gain value and be worth more money. When IV increases, it will usually increase more for the long term options since their vega is higher. The trade is vega positive which means it benefits from the increase in IV.
What is the risk?
The maximum theoretical risk of the calendar spread is the debit paid. If we hold the trade till the expiration of the long option and both options expire worthless, the trade will lose 100%. Of course we should never allow this to happen. As a general rule of thumb, the average loser size should not exceed the average winner size. We will see how to adjust a calendar trade that went into trouble.
Calls vs. puts
In general, there should not be a significant difference between calendar spread using calls or puts. The P/L graph is usually very similar. When opening a double calendar, I tend to open the upper strikes with calls and the lower strikes with puts. The reason is that OTM options tend to be slightly more liquid, and there is no assignment risk.
Can I be assigned on my short options?
If your short options become ITM, you can be assigned. If you have a call calendar spread, you will own the long calls and short the shares. If you have a put calendar spread, you will own the long puts and long the shares. In both cases, the long options will offset any gains or losses in the shares, so the final result would be similar to owning the calendar spread.
Assignment by itself is not a bad thing - unless it causes a margin call and forced liquidation. Worst case scenario, the broker will liquidate the shares in pre-market, the stock will rise between the liquidation and the open and the puts will be worth less. Otherwise, you are 100% covered - each dollar you lose in the stock you gain in the options.
You have two choices when it happens. First is just to let the short options to expire - since they are ITM, they will be exercised automatically, you will be short the shares and it will offset the long shares you were assigned. Second is just to sell the options and the stock at the same time. Both choices will produce a very similar result. You can ask the broker exercise the options as well, but this is like the first choice.
When and how to adjust?
Now, this is the key to successfully trading the calendar spreads. We will be very happy if the stock just continues trading near the strike(s), but unfortunately, stocks don't always cooperate.
You need to have a plan before you place the trade. Look at the P/L graph. Identify the breakeven points at expiration. This is where I usually adjust.
The general idea is to keep the stock "under the tent". So if I started with a single calendar spread, I might open another one in the direction of the move. For example, if I opened the 145 calendar spread with the stock at 145, and the stock moved to 146, I might open the 147 calendar. This will double the original investment, so the alternative is to sell half of the 145 calendar and use the proceeds to buy the 147.
If I started with a double calendar spread, I might open the third one. For example, if I opened the 144/146 when the stock was at 145 and the stock moved to 147, I might add the 148, instead of 144 or in addition. Again, the idea is to move the tent and to balance the delta.
Directional or non-directional?
At SteadyOptions, we trade non-directional trading. So in most cases, we will want to be as delta neutral as possible. If the stock moves up, the trade will become delta negative. To reduce the deltas, we will adjust as described. However, sometimes I'm okay to be slightly delta directional to balance my other positions. So if the stock moved up and the trade became delta negative, but I have some other positions which are delta positive, I might give it some more room and wait with the adjustment. Of course I don't want to wait too long, otherwise the loss might become larger than I would like to allow.
Using OTM Directional Calendar Spreads provides a good explanation about directional calendar spreads.
General rules/guidelines when trading calendar spreads
- Always check the P/L graph before placing the trade. You can use your broker tools or some free software. I usually use the ONE software to generate the graph.
- Avoid trading through dividends date.
- Avoid trading through major news like earnings announcements. The only exception to that rule is when you want to take advantage of the inflated IV of the front month, but those are highly speculative trades which might have a significant loss if the stock has a large post-earnings move.
- The front month options should expire in 5-7 weeks - unless you use weeklys which is usually more aggressive trade due to the gamma risk mentioned above.
- Have an exit plan before you enter the trade. My profit target is typically 20-30% and my mental stop loss is around 15-20%.
- Trade stocks which are in a trading range.
- Most of the time calendar spreads work better when IV is low. Those are vega positive trades which means they benefit from increase in IV.
- Aim for a long option near the low of its IV range. This gives it room to rise.
- Avoid lower priced stocks - the trade will be too cheap and commissions consuming. As a rule of thumb, stocks under $50 usually are not suitable for calendar spreads. For example, if the trade costs $0.70, with $3 per spread round trip commissions the commissions will eat over 4% of the trade value, not including rolls. If the spread is $3, the commissions will be just 1%. Over time, it will make a huge difference.
Pre Earnings calendars
At SteadyOptions, one of our favorite strategies is pre-earnings calendars. This strategy takes advantage of special IV skew between long and short options. This strategy is among our most profitable strategies. We have used it with great success on stocks like GOOG, AMZN, NFLX, TSLA etc.
Pre-earnings calendars (or double calendars) use short options expiring few days after earnings. The idea is that for some stocks, the short term options will lose value faster than the longer term options, causing the calendars to widen. For those stocks, the IV increase of the short options just cannot keep with the negative theta, and the options lose value despite IV spike. For example, GOOG short term straddles/strangles were consistent losers due to the accelerating theta, so we are basically short those options and long options expiring 1-3 weeks later.
Want to learn more about the calendar spread strategy and other strategies that we implement for our SteadyOptions portfolio?