Option strategies that limit your risk: Buy a Calendar Spread

The primary reason for entering a Calendar Spread is to take advantage of disparities in volatility between near-term options and options of a deferred month. By selling a short-term option with a sharply higher volatility than a longer-term option of the same strike price, a trader can establish a position that can be profitable over a wide range of underlying prices. You should only enter a Calendar Spread if volatilities warrant their use and you feel confident that the underlying stock or futures market will remain in the profitable range.

For example, say XYZ stock is trading at 65 in March. The May 65 strike put option is trading at 14.50 with an implied volatility of 24. At the same time the August 65 strike put option is trading at 18.75 with an implied volatility of 20. The near-term option (May) is trading at a volatility that is 20% more than the longer-term (August) option. The price of the May option in this example is comprised solely of time premium. As expiration nears, this time value will decay to zero. While the August option will also lose some time premium, it will not lose nearly as much as the near-term May option. This trade will show a profit at expiration if the price of XYZ stock is between approximately 40 and 109. Outside of this range, losses will occur. The profit/loss graph of a call calendar spread has the same general characteristics and shape as the put calendar spread



For example, say XYZ stock is trading at 110 in August. The September 110 strike call option is trading at 5 with an implied volatility of 24. At the same time the October 110 strike call option is trading at 6 with an implied volatility of 20. The near-term option (September) is trading at a volatility that is 20% more than the longer-term (October) option. The price of the September option in this example is comprised solely of time premium. As expiration nears, this time value will decay to zero. While the October option will also lose some time premium, it will not lose nearly as much as the near-term September option. This trade will show a profit at expiration if the price of XYZ stock is between approximately 104 and 118. Outside of this range, losses will occur.


As a result, traders must be prepared to cut their loss if needed when they enter a Calendar Spread. Calendar Spreads can be entered using at-the-money options or out-of-the-money options. Using at-the-money options (Type A Calendar Spread) is a "neutral" strategy, in that it does not require the underlying security to make a particular move in order to be profitable. Using out-of-the-money options (Type B Calendar Spread) does require that the market move in a particular direction in order to generate maximum profits. Type A trades offer a higher probability of profit by virtue of being approximately delta neutral.

When To Exit Calendar Spreads

Exiting at a Loss
Determine maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit the entire position.

Exiting at a Profit

1. Inspect a theoretical profit/loss graph to determine price area of peak profitability.
   
2. If 80% of maximum profit is obtained, close 1/2 of your position and set 1/2 of your open profit as a trailing stop.
   
3. Raise trailing stop as profits continue to rise.
   
4. If trading Type B (out-of-the-money) Calendar Spread and the underlying reaches peak profit price, exit the entire position.