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Calendar Spreads – The Math Is Not Too Complicated

Remember how boring math class was? I was always getting in trouble and when once asked to explain pi r square, I replied, "Pi are not square, pi are round." (Principal's office …)

With options, it's not as boring and, in my opinion, not as complicated as geometry. 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.

The 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.

You also get hit with a collateral requirement. With a 1-to-1 relationship, the collateral is normally 50% of the net differences between strikes of short and long; in a ratio situation, you have to deposit 100% of the strike value of the uncovered short position.

A ratio 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 the increase in 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 you to create profits while managing your risks.

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