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September 11, 2014

Calendar Spreads

A calendar spread, or what it is sometimes referred to as a time spread or horizontal spread can be a simple and quite useful option strategy. The calendar spread is designed to work somewhat like a covered call but without the potentially huge outlay of cash that can accompany buying shares of stock. The spread profits from time decay (option theta) and can make money in any direction depending on the strikes that are chosen. The spread can be set-up with a bullish, bearish or neutral outlook on the underlying either using call options or put options.

How to Create a Calendar Spread

Creating a calendar spread involves buying and selling options on the same underlying with the same strikes but different expirations. The best case-scenario is for the stock to finish at the strike price allowing the short-term option to expire worthless and still have the long option retain much of its value.

For the sake of this example, close to at-the-money (ATM) options will be used but out-of-the-money (OTM) and in-the-money (ITM) options can also be used depending if there is a bullish or bearish bias. As a general guideline, if I have a bullish outlook on the underlying I use call options and put options for a bearish bias. The reasoning is that OTM options generally have tighter bid/ask spreads than options that are currently trading ITM. Initially being down less money entering any option trade due to a tighter bid/ask spread is always a good thing.

Simple to Follow Example

In late August, Marriot International (MAR) was trading just over $69. The stock has been slowly rising over the last year. The trader forecasts that the stock will still be about the same price or maybe a tad higher by September expiration. This scenario makes it worthwhile to look at a calendar spread. MAR has September and October expiration’s available. The trader can buy the October 70 call for 1.25 and sell the September 70 call for 0.55. The total cost of the calendar spread is 0.70 (1.25 – 0.55) and that also represents the most that can be lost.

If the stock remains relatively flat as September expiration approaches, the calendar spread’s value should increase. Hypothetically, with about a week left until September expiration the October 70 call might be worth 1.00 and the September 70 call might drop to 0.15. The spread now would be 0.85. A profit could now be made of $0.15 (1.25 – 0.55). That doesn’t sound like much but a $0.15 profit on a $0.70 investment in a couple of weeks is not a bad return in my opinion.

The whole key to the success of the calendar spread is the stock must not have huge price swings. If the stock falls more than anticipated, the spread’s value will decline along with the stock. If the stock rises well above $70, the short September 70 call will partially or fully offset the increase in the long October 70 call depending on how much the stock rises.

Conclusion

There are other factors that can affect a calendar spread like implied volatility skews that can both help and hurt the spread. It is advantageous for the implied volatility to be higher for the short option versus the long option. This way the more expensive premium is sold and the cheaper is purchased. This component will be discussed in greater detail at a later time.

The beauty of the calendar spread is that it almost functions like a credit spread without the added risk. The risk with a credit spread is that it may suffer a substantially greater loss than a calendar spread if the stock moves in the opposite direction of the outlook due to high risk and low reward scenario that accompanies most out-of-the-money (OTM) credit spreads.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 10, 2014

Double Your Pleasure

With earnings season just kicking off once again, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

July 25, 2013

Seeing Double

Today we will talk about a subject that is brought up quite often in MTM Group Coaching and Online Education and is often debated by option traders learning to trade advanced strategies; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals

Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options.

The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in optionspeak, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of placement of the long strikes closer to ATM responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions impacts negatively double calendars more strongly than it does double diagonals.

In future writings, the selection of strike prices and position management based on the volatility of the stock will be discussed. In addition, other option strategies will be introduced and guidelines will be discussed to help the trader select among these similar strategies when considering trades and alternatives.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring