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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • The Ratio Calendar Spread - Options With Creativity 6 comments
    May 4, 2013 2:09 PM

    One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position. This works not only with calls, but also with puts.

    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. 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 very risky. But selling four short and buying three long is less risky; there is a greater degree of coverage involved.

    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:

    1. 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.

    2. Even if the short positions move in the money, they can still be closed at a profit if and when time decay outpaces intrinsic value. This occurs frequently, especially as expiration approaches.

    3. 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 applied 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.

    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.

    To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

    I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

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Comments (6)
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  • voyager07
    , contributor
    Comments (3) | Send Message
     
    Is it possible to have a stop loss type order to absolutely protect against the catastrophic loss?
    22 May 2013, 08:45 AM Reply Like
  • Thomsett
    , contributor
    Comments (140) | Send Message
     
    Author’s reply » Of course you can enter any form of order you wish, but it makes more sense to me to set up strategies that won't become catastrophic ... that seems more prudent.
    23 May 2013, 09:40 AM Reply Like
  • peterevanson
    , contributor
    Comments (3) | Send Message
     
    Yes, The calendar spread is one of the easier to understand and manage option trading strategies. Hence, it is a popular and usually considered as a neutral trade.
    18 Jul 2013, 02:05 AM Reply Like
  • Thomsett
    , contributor
    Comments (140) | Send Message
     
    Author’s reply » I agree; it is also a creative way to expand and hedge other strategies, notably to roll losses forward to create gains without additional risk.
    18 Jul 2013, 08:38 AM Reply Like
  • JasonC8847
    , contributor
    Comments (326) | Send Message
     
    Do you think it would also be good to do a two month calendar spread using the RUT, months Sept and Oct at 1040 strike? The difference in price is only 4 dollars between the two months ($25, $29) so there is little risk with the two moving away from eachother and creating a loss.

     

    Assume a two month calendar trade and use 25-50% or your anticipated gains to hedge for large moves.

     

    If you add verticals to both the up side and down side as protection you can create a pretty secure position.

     

    Would you consider this good hedging?
    29 Jul 2013, 07:47 PM Reply Like
  • Thomsett
    , contributor
    Comments (140) | Send Message
     
    Author’s reply » It might be, but also be aware of the collateral requirements for uncovered short positions. You are required to deposit 100% of the strike value if the call or put is not covered; partial cover (i.e. offsetting positions) reduces this, but the need for this collateral is easily overlooked. A valuable and free resource for all traders is the CBOE Margin Manual - download at http://bit.ly/14fJ3Hs
    30 Jul 2013, 08:34 AM Reply Like
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