Hey everyone.
This is Kirk, here again at optionalpha.com.
In this video tutorial, I want to talk about how you would go about adding or trading a
put calendar spread.
Remember that long put calendar spreads profit from a slightly lower move down in the underlying
stock inside of a given range and they also profit from a rise in the implied volatility
and therefore are a low-cost way of taking advantage of low implied volatility options
and markets.
If you download our strategy guide that we have inside of our membership area at optionalpha.com,
you know that we’re big fans of calendars when implied volatility is very, very low.
That's the key here.
They got to be low implied volatility and you can use these calendars to get a little
bit directional in your trading.
How do we setup this trade?
The first thing that we’re going to do is we're going to sell the front month out of
the money put option.
Front month options, we typically target anywhere between 20 and 45 days or so, maybe around
30 days.
That’s the example that we’ll be going over today in this video.
The next thing that you’re going to do is you’re going to buy a back month option,
so the next monthly contract out and you’re going to buy an out of the money put at the
exact same strike price.
We’re really trying to hyper focus here on the differential between the contract months,
not so much the difference between the strike prices.
You got to trade these at the exact same strike price.
What’s the risk?
Your risk is limited to the width of the net debit paid for the spread.
If you paid a debit of $1.50 for the calendar, your risk is just limited to $1.50.
It’s a very low-cost way to trade options.
Profit potential can vary with these strategies because of the decay in the back month option
that you’re long, so ideally, you are looking to target your profit at the value of the
sold front contracts.
If you sold the front contract for somewhere around $.30 or $.50, maybe that’s what you
might be looking to get as far as premium on the spread that you bought.
Profit potential is maximized if the stock settles at the strike price at the front month
expiration.
That’s where our profit loss diagram to the left of the screen really peaks out, is
if the stock settles right at our strike prices because our front month contract would expire
completely worthless (remember that we sold that front month contract) and our back month
contract that we bought is going to have still some value left because it still has some
time until it expires in the next contract month.
As far as volatility goes, these positions definitely have a positive impact when implied
volatility is increasing.
Volatility tends to show a greater boost in the value of the back month option that we’re
long because it has more days compared to the negative impacts of the front month option
that we’re short.
Try to take advantage of these two different contract months.
Increasing volatility or Vega is going to have a really big impact on our position especially
in that back month option that we’re long.
That's why you have to trade these from a low implied volatility market to a rising
implied volatility market.
As far as time decay is concerned, the passage of time will generally help this position.
Since we're looking to collect the value of the front month option, the closer we get
to expiration, the faster a profit will materialize and the quicker that we're going to see this
profit loss diagram actually start to mold and shape.
As far as breakeven points, they’re a little bit harder to calculate with calendars because
there’s no single way to determine them.
I always say that it’s important that you analyze a trade first before you place an
order.
We’re going to do that here right on our broker platform in Thinkorswim.
We have a trade tab up here of SPY and SPY is currently trading right now around 202.50
or so.
If we’re directionally bearish on this stock, we might go down maybe one or two strikes
out of the money.
That's typically how we like to trade these.
I might go down to say the 201 strike which is about a strike and a half out of the money
from where the stock is trading right now.
We’re going to be just a little bit directionally bearish and we’re going to hope for an increase
in implied volatility.
When it comes to placing this trade, the first thing that we’re going to do is we're going
to sell that front month option at 201.
I’m going to just click on the bid here, we’re going to sell that front month option
at 201 and then we’re going to go over to the back month option which is March and we’re
going to buy that option.
Notice the front month options have about 30 days to go, these are the February's, the
back month options which are March have about 57 days to go, so we’re selling the 201s
in February, buying the exact same strike price at 201 in March.
One little quick thing here is that you'll notice when you do these calendars, sometimes
the front month contracts have strike prices that you don't see in the back month.
In this case, the back month doesn't have the strike price 201.50, so you want to make
sure that you're doing strike prices that are exactly the same in both contract months.
This calendar spread here cost us a debit of 174, so it’s a little bit more expensive
than we usually like to pay.
We like to pay around $125, $140 or so for a calendar spread, but a little bit more expensive
gives us a little bit more premium to work with.
As far as the profit loss diagram though, it’s very, very attractive for this calendar.
You can see this is that peak that we see in the profit loss diagram from the slides
before.
This is where the stock ideally should try to pin at expiration which is around 201 as
far as a price.
The stock is trading right here.
This is the dotted line on the graph.
This is where the stock is trading, about 202.5.
You can see we’re just a little bit directionally bearish on this trade, so we need the stock
to move down just a little bit to make some money on this trade.
But what's great about this calendar is that our breakeven points are about 206.5 to 195.5,
so we’ve got a very wide window to make money on this trade which is great.
Even though it cost us a lot of money upfront, about $174 to enter this trade, we’ve got
a very wide window of opportunity to make some money.
As far as key takeaways go, these are definitely low implied volatility strategies that work
best when you’re using strike prices one to two levels out of the money in the direction
that you want to trade.
The further you get with your strike prices as you get further and further out of the
money, the more and more directional this trade becomes.
It's important that you keep these strike prices just a couple of levels out of the
money to really maximize the potential of the strategy.
We suggest closing the spread completely at front month expiration whenever possible.
Really, this means that you close out the trade when you get to that front month expiration.
In the example we just went through, that would be February expiration, about 28 days
from now, so you want to close out the strategy regardless of what happens at February expiration.
You’re not going to carry it all the way through to March expiration.
As always, I hope you guys enjoy these videos.
If you have any comments or questions, please add them right below in the video lesson page.
Until next time, happy trading!