Track That Trade 110629. Calendar spreads

Calendar spreads. An introduction

A calendar spread is also known as a ‘time spread.’ It is composed of two options with the same strike price and different expiration dates.

To BUY the calendar spread, buy the longer-term option and sell the short-term option. This is more common strategy.
To SELL the calendar spread, buy the shorter-term option and sell the long-term option. This how the trader exits the trade.

The trade is straightforward for the option beginner. The idea is for the stock to be near that strike price when expiration arrives. That provides the maximum profit. For example, I bought 5-lots of an AAPL call calendar:

Trade 1

    Buy 5 AAPL Aug 19 11 335 calls
    Sell 5 AAPL Jul 15 11 335 calls

Debit paid per spread: $3.90 Error corrected. The debit is $6.90

    *NOTE: This spread requires payment of cash, but it is not called a debit spread. That term is reserved for spreads with options that expire at the same time.

ATM call spread for AAPL. Figure 1

The dotted line represents the projected profit/loss (assuming IV is unchanged. The purple line represents a 15% boost in IV, and the green is 15% lower) late in the afternoon, Jul 15. Note that the maximum value occurs when the Jul calls expire worthless and the Aug calls are ATM. As a reminder, ATM calls have the highest time premium. The trader sells the Aug calls and earns the profit ($2,700, as indicated by the y-axis)

The table shows the greeks for each option (plus others that are discussed later). NOTE: I suggest not using more than two decimal places.

The Greeks. Figure 2

Trade 2

This time we bought 5-lots of a call spread that is in the money. This is bearish play earning it’s best profit when the stock moves near 300.

    Buy 5 AAPL Aug 19 11 300 calls
    Sell 5 AAPL Jul 15 11 300 calls

Debit: $2.85

ITM call spread for AAPL. Figure 3

Trade 3

Out of the money call spread. This is a bullish trade because the stock must move higher for the options to gain in value. [Once again this is from the beginner point of view. I’ll expand after I complete the beginner discussion]

    Buy 5 AAPL Aug 19 11 370 calls
    Sell 5 AAPL Jul 15 11 370 calls

Debit $2.10

OTM call spread for AAPL. Figure 4

Trade 3a

The OTM call spread – but without bothering to sell the Jul calls. They would fetch only $0.10 – and for that price, I’d rather not bother with the sale. If the stock rallies and the Jul 370 C can be sold at a higher level, I would elect to sell at that time. If that does not happen, the sacrifice is that dime.

    Buy 5 AAPL Aug 19 11 370 calls

Debit $2.10

figure 5. Long Aug calls

Figure 5. Long AAPL Aug OTM calls

Is That All There Is?

No. There’s more.

To the new trader. the idea is to buy a calendar spread such that the near-term option is close to being ATM when expiration arrives. It should be pretty clear that the trader may get this right on occasion, but it’s not a likely outcome.

That means there is a point at which the calendar spread buyer should be looking to close the position and accept the profit. If you ask why not keep holding and collecting that nice time decay, it’s the expected answer: Being short near-term gamma adds risk to the position. As can be clearly seen in each of the first three risk graphs above, as the stock moves away from the strike price – in either direction, the value of the spread declines. That’s why it’s can be a good idea to exit and lock in a gain.

For example, if we own the 300 call spread (Trade 2 above) and AAPL is volatile enough to decline to 300 next week, it could easily move much farther and the profits would disappear. Or, the stock culd reverse direction and the opportunity to exit at a profit will disappear.

Reminder: This is not a good trade to hold to expiration, despite the fact that many traders do. If you want those extra profits (by holding and hoping that expiration arrives with no additional stock price movement), you will be forced to take more risk. A poor risk/reward play in my book.

Volatility and calendar spreads

When you move beyond the novice stage, there are other factors to consider when holding a calendar spread. Look at the greeks for any of these trades and note that vega is between 111 and 145. For this small position, an IV change of 10% (from 30 to 33) would increase the value of owning the position by $333 to $435. That’s a fair sum, considering that it’s a small position.

Owning calendar spreads is a play on vega. If implied volatility rises, the calendar spread should be a winner – if the stock does not move too far.


There is a huge caveat. If you want to own vega because you believe (or fear) that IV will be rising soon, calendar spreads are good to own. However if the volatility explodes over a short time period, that is a far different story and calendar spreads tend to lose money.

This comes as a surprise to many traders. And it’s understandable. If long vega, why would the calendar spread lose money in a wildly volatile environment. Let’s take a look at Figure 1 – the ATM calendar.

Th Jul 335 calls carry a vega of 22 (111 total vega divided by 5)
Aug 335 calls have a vega of 50.

If AAPL plummets to 300 today, then the Jul IV could easily double (from 21* to 42) as traders panic into buying front-month options for gamma protection. The Aug calls may see IV rise from 26* to 35. [Obviously these are estimates]

    This data comes from the 2nd figure above, the table of greeks.

Jul calls increase in value by 21 * 22 = 462 [21 = IV increase; 22 is vega]
Aug calls increase in value by 50 * 9 = 450 [9 = IV increase; 50 is vega]

Don’t take these estimated volatility changes as anything more than an example. In this case, the loss is essentially zero. However, in extreme cases, front month IV can increase by significantly greater amounts when compared with longer-term options.

That’s why calendars are great is a rising IV environment, but too much of a good thing is bad.

Update June 30, 2011

The market is higher and AAPL is 335. VIX and RVX are lower, but AAPL implied volatility is holding.
Not that the ITM spread shows a small gain, while the ITM spread does not (and it shouldn’t. It has negative delta)

The trade, one day later

The greeks

Update July 5, 2011

AAPL + another 6 points

As I update this at roughly 1PM CT, AAPL is trading @ $348.84.
Let’s take a look at each of the calendar spreads.

AAPL option data

AAPL option data

1) Aug/Jul 300 C spread

AAPL Aug/Jul 300 C spread. Jul 5, 2011. AAPL = 349

This spread has a current value near $1.45. That represents a loss of approximately 50% of its initial value. That’s not surprising. The deep ITM call spread began life delta short and with the stock rising, the negative delta means that we were ‘short’ for then entire ride. The small positive gamma did not provide any meaningful help.

Because it was a bearish trade, it lost money as AAPL rallied significantly. I see no reason to hold this trade. If this were in my portfolio, I’d give it up and take the loss. The only hope for holding is a swift decline in AAPL shares, or an otherwise unexpected decent increase in the implied volatility of the options. That would help because the trade has positive vega (figure 3).

2) Aug/Jul 335C spread

AAPL calendar spread

AAPL Aug/Jul 335 C spread. Jul 5, 2011. AAPL = $349

We paid $6.90 for this spread, and it’s currently priced near $6.10. Trading ATM calendar spreads is tricky. I tend to avoid this particular strategy, however, the spread is going to reach maximum value if and when the stock is very near the strike price when expiration arrives. As I am certain everyone recognizes, that is an uncommon event. That means it requires some good decision making to know when to exit this trade.

In my opinion, I prefer to exit when The stock moves near the strike price and accept the fact that I may not have the maximum profit, but I should have earned a profit. Of course, if you open the trade when the options are currently ATM, then the question becomes how long to hold the trade. We earn cash day after day with positive theta. However, we lose money as the stock drifts away from the strike, due to negative gamma.

As we look at this position now, there is one thing to recognize. This spread is trading at more than $6, and as you can see from the Aug/Jul 300 call spread – this premium can shrink and a reasonable amount of cash can be lost. Thus, holding is not risk free.

If bearish, and if you want to wager on a down move, then holding – with the intention of exiting the trade if and when AAPL approaches 335-337 is one possibility.

Anogther reasonable choice is to buy back one of the Jul calls, adding 85 delta to the position and making it delta neutral going forward. The extra call option earns money on a ally – compensating for the fact that the calendar spread will loss value. If the market falls again, the extra call with result is a loss, but, that will be compensated for by gains resulting from an increase in the value of the calendar spread. If the stock tumbles, then buying that one lot of Jul 335 C will turn out to be a losing trade.

***Please note: The fact that it may turn out to be a losing trade does not man it was a bad trade or a poor decision. The best decisions cannot be expected to turn out profitably every time. On average, good decisions earn extra cash for the trader and por decisions lose cash. But no conclusions should be drawn from any single trade.***

Here’s a risk graph after this adjustment: buying once Jul 335C

Adjusted APPL Aug/Jul 335C spread

Adjusted APPL Aug/Jul 335C spread

Note how flat the curve is around the current price. That’s what zero delta and zero gamma can do for a position. Of course, on a big move, the single extra call yields a nice profit on the upside and a significant loss on the downside.

3) The 370 Call spread.

As you recall, we chose not to sell the Jul 370C cor only a dime.
Today we have two choices: Sell those calls for about $0.35 or exit the trade, taking a profit ($2.50, or 119%) on the long Aug 370 calls.

This spread (or single long call) acted as expected. As the stock rose, so did the value of the OTM call spread.

Please notice that there is a small, but nice little extra profit that cam from making a reasonable decision not to sell the front-month part of the calendar spread. This is NOT an endorsement to buy OTM calls as a speculation. It is merely this: I want you to recognize that sometimes selling an option at a very small price is just not worth the bother. Most of the time that small extra sum will disappear. However, every once in a while you can earn a little bonus. And if you don’t want to sell at 35 cents here, you can hold out longer. Of course, at this level, the call is worth selling and is no longer ‘too small to count.’ Not selling here is a decision to ‘gamble.’

6 Responses to “Track That Trade 110629. Calendar spreads”

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