Would you like to profit from sideway markets or stocks? Would you like to take advantage of the different time decays and different Implied Volatility in different expiration months? Then calendar spreads might be for you.
A calendar spread is a strategy involving buying longer term options and selling equal number of shorter term options of the same underlying stock or index with the same strike price. Calendar spreads can be done with calls or with puts, which are virtually equivalent if using same strikes and expirations. 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.
Let's take a look at a sample Apple (AAPL) trade which I shared at my Premium Educational Forum on March 11, 2012:
- Sell AAPL April 545 call
- Buy AAPL May 545 call
The trade could be done last Thursday after the iPad announcement for a debit of $7.50-7.60. The P/L graph looks like a tent:
The maximum gain is realized if the stock is at $545 by April expiration. If this happens, the April call will expire worthless but the May call will still have value. How much value? Depends on IV (Implied Volatility) at that moment. We can estimate that it might be around $16-18. So with initial debit of $7.50, the trade will give us over 100% gain. I personally would close it much earlier. My profit target of calendar spreads is typically 20-30%.
How the calendar spread makes money?
The first way is the 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 to say $650, both options will have very little value and the spread will shrink. Of course $650 is a bit extreme move in one month, but you get the idea.
The second way a Calendar Trade makes money is with an increase in 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. In case of Apple, IV of the April options was high due to the pending iPad announcement and was expected to go down.
Managing the position is the key. What happens when the stock makes a significant move and the trade starts losing money? Having an exit plan before entering the trade is extremely important.
Here are some basic rules and guidelines to follow with calendar trades:
- Always check the P/L graph before placing the trade. You can use your broker tools or some free software. I generated the P/L graph using the OptionsOracle software.
- 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.
- 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%.
- If the stock reaches one of the break-even points, I would typically adjust by opening another calendar spread around the current price, converting it to a double calendar.
- Trade stocks which are in a range or having a positive volatility skew (front month IV is higher than back month).
- Never hold through the expiration week of the front month to avoid the gamma risk.
- Most of the time, placing the trade with puts will be cheaper than with calls.
- 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.
Those are my rules, yours might be different. They just fit my comfort zone.
So how is our Apple calendar spread is doing?
Well, with the way the stock is moving in the last few days, you would assume the trade is a huge loser. However, since the April IV went down after the iPad announcement and the May IV went slightly up, the trade could be closed this Tuesday for around $8.50. In fact, even yesterday (Wednesday), the trade could be still closed at 8.30-8.40, even with the stock at $582. That's 10-13% gain, despite the huge movement of the stock.
Always make the Implied Volatility your friend. It will save you a lot of money.