The Calendar spread is an excellent trading strategy the delta neutral trader can employ to consistently garner profits in the market. In this installment we will perform a walkthrough of a real world calendar spread demonstrating the key filters and steps that need to be applied when putting together the best possible strategy with the highest likelihood of being profitable.

The type of calendar spread we will employ is the at-the-money put calendar. Keep in mind the same rules apply to the at-the-money call calendar. For review purposes, the construction of the at-the-money [ATM] put calendar involves buying an ATM long put with a distant expiration and selling an ATM short put with a closer expiration. Note that the number of contracts that are bought and sold are the same number.

To correctly select a profitable ATM put calendar spread there are certain filters that need to be applied. The first filter that the trader wants to apply to stock selection is to locate an underlying equity that has been gyrating in a well-defined channel over the last 90 to 120 days. The channel should have well defined support and resistance points. Second, make sure there is no catalyst like an earnings announcement in the period of time that you will be selling the front month.

You do not want any type of event that could cause the underlying to move out of its sideway channel. If earnings are scheduled make sure that it has been a typically calm event in the past. The ATM put calendar is designed for stocks that are trading in a very distinct trading range. Also, make sure implied volatility is low especially the volatility level of the long put.

In our real-world trade this week we will look at Dollar General (DG) and just why this is possibly a good candidate for an ATM put calendar spread. First, as can be seen in Figure 1 below an ATM put calendar spread has been constructed by buying 1 August 2006 17.5 Put and at the same time selling 1 June 2006 17.5 Put for a $20 debit. Notice the high rate of return possible over the next 31 days for this delta neutral strategy.

 

 

Figure 1: Dollar General ATM Put Calendar Spread Trade Summary

Next, the options strategist needs to evaluate the current implied volatility of Dollar General. As you can see in Figure 2 below, the current implied volatility is relatively low, which is an advantage for the ATM put calendar spread.

 

 

Figure 2: At-the-Money Implied Volatilities for Dollar General

Figure 3 shows the stock price chart of Dollar General over the last 6 months along with its associated ATM put calendar spread risk graph side by side. Also, notice that the risk profile shows profits being generated within the breakevens and the position losing money if the price breaks outside the breakevens. This particular graph demonstrates just how DG has been channeling over the last 4 months.

 

 

Figure 3: Dollar General Price and Risk Graph

To summarize the selection process for the ATM put calendar spread, remember that first it is important to locate a stock like Dollar General that has been trading in a specific sideways channel for the past 90 to 120 days. Second, make sure it is exhibiting relatively low implied volatility especially in the back month. As a guideline the trader typically wants implied volatility to be less than 30 for the ATM calendar spread.

Next, verify that there are no major events or catalysts happening within the time frame of the short month. If there is an earnings announcement then look back and make sure the announcement had little impact on the stock price, otherwise avoid the trade. Finally, the trader needs to closely examine the associated price and risk graph to make sure it makes sense visually that the stock price can stay within the breakevens until the short month expires.

Always verify that the risk graph makes sense before implementing the ATM put calendar spread. Keep the debit as low as possible. The ATM calendar spread can be rolled each month, if it still makes sense, until eventually there is a good possibility the trader will have a free and clear adjustment. This is one of the biggest advantages of delta neutral calendar spreads is that they can be adjusted each month to lower the risk and improve the reward. As we go forward we will attempt to identify the best real world delta neutral strategy for that particular week while at the same time always emphasizing how we selected and implemented the strategy.

Happy Trading.


Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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