Trading Calendar Spreads with Options
January 31, 2006
There are several different ways to trade the calendar spread, and trading with a system that suits you is imperative to being profitable. In this article I am going to explore:
- What a calendar spread is
- What to look for
- What to avoid
- One of the common ways calendar spreads can be traded using Platinum
Before going any further, let’s revisit what a calendar spread is:
Calendar Spread Definition
A long calendar spread consists of buying an option and selling an option with the same strike price. The bought option has more time to expiry than the sold option.
The main objective with calendar spreads is to take advantage of a sideways moving security through the use of time decay (theta). This is achieved through selling an option where the time decay is large whilst minimising risk through buying an option where the time decay is less severe.
Figure 1 below shows the effect of time decay on an option. The green line displays the time decay experienced in the long option whilst the red line depicts the time decay of the short option.
Figure 1: The Difference in Time Decay of Calendar Spread Options
The system I wish to share with you involves selling an option with 25-45 days until expiration and buying an option with slightly more time value—for example, selling a February option and buying a March/April/May. We are only looking at being in the trade until the front month’s expiration, and when this occurs the position is closed. Other criteria that must be met include:
- Maximum profit/risk must be at least 100%. This means we have the potential to double our money within one month.
- The stock has a history of being range bound. We want the stock to move sideways. If a stock has a history of trending up or down with little sideways moment, it is not a good candidate.
Figure 2: Daily Chart, Cisco—An Example of a Stock Trades in a Range
- We want to see that for the past month the stock has been trading predominantly within the two breakeven lines.
Figure 3: Range Bound Stock with a Recent History within Breakeven Lines
- Implied Volatility [IV] is low; remember that volatility is how the market makers control the price of the option. If the IV is high relative to the past, then the market is expecting the stock to move. This is not how a calendar spread makes money! Make sure the IV in the option you are selling IV is at least equal to, if not greater than, the IV in the bought option.
Figure 4: IV Chart Where the Current Level is Low
The bullet points above list the criteria which must be met. There are also a few things to avoid with calendar spreads. They include:
- Trading companies involved in corporate action such as a merger or acquisition. As with all strategies, always check the news for the stock under consideration. This can be done by looking on the Optionetics website, www.optionetics.com.au.
- Avoid calendar spreads on companies that are going ex-dividend before the short month’s expiration.
- Check to see when the next earnings announcement is expected. If the next announcement is before the short month’s expiration, you need to check to see if the stock has a history of large movements at earnings. If it does, move on to the next candidate. There are several websites that provide this information at no cost, and usually a company’s website will detail this information.
Using Platinum to Find Calendar Spreads
There are several ways to find calendar spreads with Platinum including Gyration Finder, Skew Finder, Platinum Smart Search and Find Trades III.
Let’s explore Find Trades III. Under Search Tools, click on Find Trades III. Under Selected Stock List, go to the list you wish to scan. If you want to scan all Optionable stocks and don’t have this list, it can easily be created within Platinum. This is achieved by clicking on Stock Rankers and then Percent Change. Fill in the parameters as below in Figure 5 and click on ,b>Ranking. When the results are displayed, select an empty quote list, rename it Optionable Stocks and click on Save.
Figure 5: Using the % Change Feature to Create an Optionable Stock List.
Now that we have an Optionable Stock list, go back to Find Trades III and select the list. Scroll down until you reach the Strategy Wizard, select Put Calendar and click on Go. This loads the wizard’s settings.
Figure 6: Search Wizard in Find Trades III
Scroll down to the Expiration and Time Filters and change the numbers as shown below in Figure 7. As you become familiar with the scan you may wish to modify the suggested setting so that the scanner shows you exactly what you want, as below.
Figure 7: Customising the Time Filters
There is one last thing we need to do before running the scan. Scroll up to the top of the Find Trades III screen and give the scan a name, such as Put Calendar Scan, and click on Save. Now you are set to scan for calendar spreads. In the future, if you wish to run this scan all you have to do is select the stock list, select the ranker, click on Replace and then Scan.
From the scan results, isolate the stocks that are trading close to the strike price and meet the minimum 100% profit/risk requirement. From the scan results screen you can click on the trade description to open the risk graph. Below is a summary of what we are looking for in a calendar spread risk graph using Platinum.
Figure 8: Key Features of a Calendar Spread Risk Graph
What if You Don’t Have Platinum?
Using the methodology described above it would be very hard to find calendar spreads without a powerful options analysis software such as Platinum. If the calendar spread strategy appeals to you then the approach detailed in the Optionetics Course Library will be more appropriate. As with the system above, you will be looking for stocks that have a history of trading in ranges, and where the IV in the sold leg is higher than the IV in the bought leg. IV data is available through all the major brokers.
Summary
If you are interested in trading calendar spreads, it is recommended that you paper trade first to ensure that the system being implemented is profitable and suits your trading style. Everyone learns at a different pace, so there is no set time frame for the length of time it will take for you to feel comfortable enough to make the switch to real trading. Once you have a solid system in place and feel comfortable with the strategy, then it is time to start using real money.
All the best for 2006!
Guy Halpin
Senior Writer
Optionetics.com
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