This works not only with calls, but also with puts. This is a straightforward, one-to-one form of the calendar spread, but it does not end there.
This calendar spread is a popular strategy; it can be expanded, however, to create a ratio calendar spread. In this twist, you sell more of the shorter-term expirations and you buy fewer of the longer-term expirations. This makes it more likely that the short premium on the first set will pay for the cost of the long positions, due to the more rapid time decay of the faster expirations on the short side. Because you end up with more short than long positions, there is risk involved. The higher the ratio, the lower the risk. For example, selling two short options and buying one long is risky because the short side is one-half uncovered. But selling four short and buying three long is less risky, because of the greater degree of coverage. This can be seen as three covered positions and one naked, or overall as 75% coverage.
A calendar spread is not as risky as it appears at first glance, even though one or more of the short positions are naked. This is true because time works in your favor. A few points to keep in mind:
- The short options are going to lose time value more rapidly than the long options. This means one or more may be closed at a profit, eliminating the uncovered option risk.
- Even if the short positions move in the money, they can still be closed at a profit if time decay outpaces intrinsic value. This occurs frequently, especially as expiration approaches.
- To avoid exercise, the uncovered portion of the ratio calendar spread can be rolled forward. The ratio calendar spread's risks can be managed by combining time decay with timing of entry (opening short positions when implied volatility is exceptionally high, for example).
The most critical point about these strategies is that the short options are going to lose value before the long options, which gives you a great advantage. Even if one of the options is assigned early, the long positions can be used to satisfy that assignment. All or part of the short side can be closed at any time to eliminate the risk, making the ratio calendar spread a good strategy with less risk than you find in just selling uncovered positions. To avoid early exercise, stay away from short exposure for stocks whose ex-dividend date occurs before expiration, or where earnings will be announced while the positions are opened; an earnings surprise can also turn into a risk surprise for the ratio position.
You add flexibility to a ratio calendar spread when you move beyond calls and look at the same strategy involving puts. If you believe, for example, that the underlying has strong support at or below a short strike level for puts, creating a put-based ratio calendar spread is yet another way to create profits.
This strategy is especially effective for short-term trading programs. Swing traders can employ the ratio calendar spread using either calls or puts to create net credit entry with minimal risks and play both sides of the swing. This is far more effective than restricting the strategy to long options and enables traders to create profits while managing their risks.
Risk cannot be overlooked or discounted, however. It is one of the great potential blind spots of options traders to overlook exactly how much risk might be involved in any strategy. How often does this occur? The strategy seemed foolproof when it was entered, but it ends up going south because the one event you did not anticipate is what happened.
To manage the risk well, be aware of all possible outcomes. Don’t fall into the trap of only thinking about profit potential. Remember that loss potential holds equal weight. There certainly are ways to mitigate risk. For example, setting up a ratio with 75% coverage (4 to 3) instead of 50% (2 to 1), drastically reduces risk.
Another way to reduce risk is to vary strikes and expirations. It is not necessary to limit yourself to one short strike/expiration and one long. The entire strategy can be set up as a box or butterfly with a ratio relationship, but this can get complicated, too. Some complex option strategies hedge loss to the point that the relatively small level of gain is not worth the need to monitor and control all the open positions.
Risk is further controlled by taking profits when they develop. Too many option traders have been known to wait out a position in the belief that today’s profit will only grow in the future. But of course, it can also shrink or even disappear entirely. You end up having better results by taking profits, closing positions, and moving on to the next great strategy; you put those profits at risk when you hesitate, hoping for even more. As they say in poker, when you have a marginal hand, it is a mistake to get “pot committed,” meaning you have to put in more cash than you want to because you have already risked too much. The same wisdom applies to options. In fact, this could be the best insight to risk.
Take profits when they are there, even if small. Equally important, take losses in the ratio position if it looks like timing was poor and the situation could get worse. Know when to fold, in other words. Gaining experience in poker could be a good starting point for improving performance as an option trader.
Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook.
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