There are several tools used by traders in the options market to realise a profit from selling options before they reach expiration period. One such tool used by seasoned options traders is calendar spread, initiated when market sentiment is neutral.
A calendar spread is initiated for different options with the same underlying asset and same strike rate but different expiration dates. It involves selling an option with shorter expiration date and simultaneously, purchasing a call or put option with long-term expiration when there is no significant movement in the market to hedge risk. It is a process for investors to earn profit from the passage of time or in a situation of increased implied volatility.
Understanding calendar spread
Investors take into account the time differences between two options to realise a profit. For its nature, calendar spread deals are also known as time or horizontal spread. It involves cashing in from stock price movement at limited risk if the market trends reverse. It is typically played by seasoned traders with several years of experience to anticipate market movement. The trader takes advantage of a change in implied volatility with other things remaining the same as long term options are likely to respond better to changes in volatility – understanding is that they can profit from the spread when market volatility changes.
Long calendar spread
It is often referred to as a time spread that involves buying and selling of a call option or buying and selling of a put option with the same strike rate but different expiration dates. If a trader sells and short-dated option and buys a long-dated option, we can say that long calendar spread is executed. It makes the deal less expensive than purchasing a long-dated option outright.
There are two types of long calendar spread – call and put. Put calendar spread offers certain advantages over call calendar spread. So, which one to exercise? The general rule of thumb suggests executing put option when market outlook is bearish and call option when it is bullish.
The first step to plan a calendar spread involves analysing market sentiment and studying market forecasts for several months. Let’s understand it with an example. A trader might plan a put calendar spread when the general market trends are expected to remain neutral for a period, but his outlook is bearish.
How to make money from a calendar spread strategy
Calendar spread tactics allow traders to make a profit from sideways markets. There are two ways to make money from calendar spread.
1. Earn it from time decay
2. Increase in Implied Volatility
The time gap signifies that short term stocks will lose value more rapidly than long-term ones, giving options to traders to make a profit from the price difference. But if the market starts to move upward, it increases chances for loss as well.
The second way to earn profit from long calendar spread is from an increase in volatility in long-term option or decrease in volatility in short-term option. Profit will increase with a rise in volatility in the long-term option.
Understanding calendar spread with a real-life example
Let’s assume an investor thinks that the market will remain stable for two months, and after that, there will be high volatility. He enters into a spread with an expiration date of 5 months from now.
The long term call will be expensive because of the time duration. The investor can offset some of the cost by entering into a spread. That is, selling one short-term and buying one long-term call by paying a premium of Rs 33.75.
Short-term call Rs 2440
Long-term call Rs 2440
Premium Paid Rs 33.75
Long-term cost without spread Rs 70.50
Scenario 1: The market rallies downward. In this situation, the short-term call expires worthless, but the investor retains the premium. This limits her loss to Rs 33.75, which is lower than Rs 70.50, the actual cost of the long-term call without the spread.
Scenario 2: The Market rises to 3000. The short-term call would have cost Rs 560. Her spread value becomes zero. In this case, he could have maximised his profit by purchasing the long-term call only.
Scenario 3: The market remains stable with no movement. The spread expires as worthless, but the long-term call remains at the money. Net profit from the spread will be ATM long-standing call minus the premium paid. He doesn’t make a loss, but income gets limited by market condition.
How to trade with a calendar spread to optimise profit
- Calendar spread options strategy is applied to any financial instrument with liquidity quotient, like stocks or exchange-traded fund (ETF) for which differences are narrow between the bid and ask prices.
- Consider trading with covered calls. A covered call in financial market refers to transactions in which investor’s selling call options match the same amount of underlying security if the buyer chooses to exercise the call option.
- Traders can enter into a spread when the market is neutral over a short span. Traders can use this legging strategy to slide over price dips in otherwise upward-moving stocks. In options trading, legging in refers to an act of entering into multiple individual positions to form an overall position to complete a deal in options.
- Traders must try to minimise their losses by taking into consideration the factors associated with – limited uptrends in early stages and different expiration dates.
- Choosing correct entry time is a crucial factor and influences the gain from the deal. An expert trader will observe market for over a period to align trading decisions with underlying trends.
- Always look at the profit- loss (P-L) graph before trading.
- Set an upper-profit limit and plan an exit when you arrive at it.
- Don’t get swayed by major earning announcements, unless you want to capitalise on inflated implied volatility. But these are highly speculative deals with risks of significant loss if the stock strikes large post-earnings move.
Managing calendar spread
Traders use this strategy when market outlook is neutral, but also when traders expect gradual or sideways movements in short-time. Selling off short-term options and buying long-dated options result in an immediate net debit. To understand the profit-loss situation and identify a good time to exercise calendar spread, use Angel One trading tools or any other software that you deem fit.