This commentary originally appeared at 7:21 a.m. EST on Jan. 6 on Options Profits – the options trader's source for daily trading strategies and actionable trade ideas. Click here to learn more.
Before we talk about trading calendar spreads, perhaps we should define what a calendar spread is. A calendar spread is two options of the same strike price but different months. Calendar spreads are also called time spreads or horizontal spreads, and they can use either puts or calls.
If we are bullish on a stock, we can buy an out-of-the-money calendar spread to express that sentiment. Let us take ConocoPhillips (COP) as an example. We took a bullish position in that stock yesterday, so this is not intended as a new trade, rather merely a didactic example. Consider buying the COP May 80 calls for $1.31 and selling an equal number of the COP February 80 calls at $0.20. This will give us a net debit of $1.11.
The spread trade will have a net delta of 0.1387, so it will behave with about the same volatility as being long 14 shares of the stock. The net theta will be in our favor at the rate of 0.0157 per day. (See the graphic at the bottom of this page for more analysis.)
This spread will achieve its peak profit exactly at the strike price. So we typically want to exit when the underlying stock is at $80. We also want to let some time pass before we exit because the positive theta tells us that the spread benefits from the passage of time. So my general rule is to let some time pass and then to exit on any crossing of the $80 strike price.
Some traders try to get more time erosion and stay with the trade, but when you are at the $80 price, if the stock goes up or down from there you will be giving money back. So I set my stop-profit target there and get out with whatever profit I have at that time. Besides, if you are bullish on a stock, there is no guarantee that it will stop at $80 -- it might just keep going to $90 and erase all your profits.
Calendar spreads can also be traded as a bearish play. Sticking with COP, we could buy the August 67.5 put for $4.45 and sell the May 67.5 put at $2.80. This would require a net debit of $1.65, which is the entire risk in this type of trade. From the graphic we can see that the net delta is -0.0206. The minus sign indicates that the spread is slightly bearish with about the same amount of price risk as being short two shares of stock. Bearish put calendar spreads also reach their peak profit at the common strike price, in this case 67.5. Again, I recommend using a stop-profit as your exit strategy to capture the peak profit available when the stock trades at that strike price.
One final note is that calendar spreads are generally forgiving around the stop-profit target. The profit graph looks like a gently rounded mountain with the peak at the common strike. At the top of the mountain, the slope is always zero. So if the stock happens to gap through the strike price, little will be lost if you simply get out near the strike price.