Options trading investors should consider using calendar spreads. In brief, a calendar spread is constructed by selling a shorter dated option and buying a longer dated option at the same strike price in the same type of option, either puts or calls. The profit engine is the difference in the decay rate of the time premium between the two options. One fundamental of options is that the time premium in a shorter dated option decays at a faster rate than that of a longer dated option.
For calendar spreads, the range of profitability extends over a variably broad range with the maximum profitability occurring at options expiration when the price of the underlying is precisely at the strike price of the calendar.
Option Calendar Spread Profitability
It is vital to understand the pertinent risk factors. Remember that option trades must be considered in terms of the risk presented by each of the three primal forces of options: time, price of the underlying, and implied volatility (IV).
In the case of a calendar trade, the passage of time and the inevitable erosion of time premium is the fundamental profit engine. Generally, risk in the calendar trade decreases with the passage of time as more of the eroding time premium accrues to the benefit of the trade.
The effect of the price of the underlying can be seen in the graph above. Note that there is both an upside and downside breakeven point and the trade must be managed with both these profitability points in mind.
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Finally, Implied Volatility, typically the most overlooked variable even though it is arguably the most important factor in deciding to use this trade structure. The starting point for considering this variable is the current status of the IV considered within a historical framework. It is important that the longer dated options not be in the upper portion of their historical volatility range. If one were to purchase these options at the initiation of the trade, there would be a significant risk of volatility collapse as the IV was to revert to its mean. This would negatively impact the trade.
Now having discussed risk factors, let us consider a higher probability trade than the single calendar. In choppy markets such as we have seen recently, higher probability trades incorporate the maximum width of price variation possible while accommodating a reasonable return on capital.
I initiated a triple calendar trade in Amgen (NASDAQ: AMGN) in late February. While this sounds complex, it is really just three single calendars established at three different strike prices. It is graphically presented below as it existed at inception:
Three-Part Calendar Spread Profitability
When considered against the light of the single calendar structure presented in the previous graph, this triple calendar has a significantly higher probability of success — 82% as opposed to the 55% of the single calendar.
At the moment, early in the final week of the March options cycle, the position is profitable at a bit over 20% of invested capital. I consider this to be an excellent result for two weeks in a high probability trade.
Options traders find life is much easier with these sorts of high probability trades which deliver solid returns on invested capital. Swinging for the fences is more exciting, but the lives of successful option traders consist of singles and doubles. These hits add up over time to deliver a robustly growing equity curve without the sleepless nights of the home run hitter.
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