Calendar spreads are a great modification of the diagonal option spread strategy. The calendar spread is useful when you are more uncertain about the direction of the market and want to increase the effectiveness of the hedge during periods of market volatility.
A bearish calendar spread consists of two options.
- The first option is a long put with a long-term expiration date. Usually traders will use LEAPS or options with expiration dates longer than a year. The long-term put establishes the bearish bias and will grow in value as the market drops.
- The second option is a short put with a short-term expiration. The short put has the same strike price as the long put you purchased. The identical strike price but different expiration dates is what makes this a calendar spread.
The ratio of the premium received from the short put to the price you paid for the long put is much larger than the same ratio in a diagonal spread. However, because the short put has a higher strike price, there are smaller potential profits if the market breaks out to the downside. I will cover the details of entering a sample bearish calendar spread in the video at the end of this article.
The larger premium compared to the amount invested in the long put creates a large hedge against upside movement in the market. If prices rise, the larger premium from the short put will offset more losses than a short put in a diagonal spread. This is be a great way to implement the benefits of a diagonal spread in the market when you are uncertain but have a bearish bias.
Diagonal spreads and calendar spreads are commonly known as “time spreads” and illustrate just two popular variations of the option spreads concept. The best way to make sure you are familiar with the trade is to experiment through paper trading. The practice will help you see how prices change as the market moves.
Watch the video below to learn more.
This article originally appeared on the Learning Markets Web site.