Calendar spread option trading

Calendar spread option trading

A long calendar spread is a good strategy to use when prices are expected to expire at the value of the strike price the investor is trading at the expiry of the front-month option. This strategy is ideal for a trader whose short-term sentiment is neutral. Ideally, the short-dated option will expire out of the money. Once this happens, the trader is left with a long option position.

Calendar Spread Strategy | Trading Calendar Spreads

Now, we will go through the Payoff chart using the Python programming code. A Calendar Spread strategy profits from the time decay and/or increase in the implied volatility of the options. In this notebook, we will create a payoff graph of Calendar Spread at the expiry of the front-month option. Importing The Libraries

How To Trade Calendar Spreads - The Complete Guide

At the expiration of the near-term option, the maximum gain would occur when the underlying asset is at or slightly below the strike price of the expiring option. If the asset were higher, the expiring option would have intrinsic value. Once the near-term option expires worthless, the trader is left with a simple long call position, which has no upper limit on its potential profit.

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Since the goal is to profit from time and volatility , the strike price should be as near as possible to the underlying asset s price. The trade takes advantage of how near- and long-dated options act when time and volatility change. An increase in implied volatility, all other things held the same, would have a positive impact on this strategy because longer-term options are more sensitive to changes in volatility (higher vega ). The caveat is that the two options can and probably will trade at different implied volatilities.

When trading a calendar spread, the strategy should be considered a covered call. The only difference is that the investor does not own the underlying stock, but the investor does own the right to purchase the underlying stock.

The ideal market move for profit would be a steady to slightly declining underlying asset price during the life of the near-term option followed by a strong move higher during the life of the far-term option, or a sharp move upward in implied volatility.

Upon entering the trade, it is important to know how it will react. Typically, spreads move more slowly than most option strategies because each position slightly offsets the other in the short term. If the DIA remains above $668 at July s expiration, then the July put will expire worthless leaving the investor long on a September 668 put. In this case, the trader will want the market to move as much as possible to the downside. The more it moves, the more profitable this trade becomes.

Assignment by itself is not a bad thing - unless it causes a margin call and forced liquidation. Worst case scenario, the broker will liquidate the shares in pre-market, the stock will rise between the liquidation and the open and the puts will be worth less. Otherwise, you are 655% covered - each dollar you lose in the stock you gain in the options.

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Here, the near month option expires worthless if the price of the underlying at the near month options expiry remains unchanged. The Calendar Spread Strategy would give a payoff resembling this graph:

Now, this is the key to successfully trading the calendar spreads. We will be very happy if the stock just continues trading near the strike(s), but unfortunately, stocks don't always cooperate.

Early assignment also changes the strategy from a calendar spread to a synthetic long put if you don’t already own shares, because you are short a stock and long a call, which is a very different outlook.

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We calculate the IV using Black Scholes model for the front-month and back-month call option. To calculate the call price for different values of Nifty, this IV will be used later as an input to the Black-Scholes model.

Based on the price shown in the chart of the DIA, which is $, we look at the prices of the July and August 668 puts. Here is what the trade looks like:

As expected, the stock price of XYZ closes at $95 on expiration date of the near term call and the JUL 95 call expires worthless. The long term call lost some value due to time decay but is still worth $855. Selling this call nets him a $655 profit after taking into account the initial debit of $755.

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