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Market volatility is the biggest scare for any trader in the market. While several options strategies are discovered to tackle the risk associated with the ups and downs of the market, traders still seem to fret at the suggestion of using option strategies. Hence, here, we are going to discuss one such option strategy that can help us in tackling market volatility as well as gain profits when prices are expected to expire at the strike price at the expiry of the front-month option. The Calendar Spread with Put options strategy<span style=”font-weight: 400;”> is used to profit from neutral stock price action at the strike price. It also limits the risk in either direction of the strike price. The maximum gain happens when the options expire at the strike price of the puts.
How Does it Work?
A long calendar spread is also referred to as the ‘time spread’. While it can be implemented using both puts and calls depending on the nature of the investor to go bearish or bullish, our focus here is going to be on the puts. It involves two major components – selling a short-term put option and buying a long-term put option with the same strike price but with different expiration months simultaneously. if a trader is selling a short-dated option and buying a longer-dated option, the result is a net debit to the account. The sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright. Because the two options expire in different months, this trade can take on many different forms as expiration months pass.
Prerequisites for the Trade
- The first step in planning a trade is to identify market sentiment and a forecast of market conditions over the next few months. Let’s assume a trader has a bearish outlook on the market and overall sentiment shows no signs of changing over the next few months. In this case, a trader ought to consider a put calendar spread.
- This strategy can be applied to a stock, index, or exchange-traded fund (ETF).
- However, for the best results, a trader might consider a liquid vehicle with narrow spreads between bid and ask prices.
- If the Prices have confirmed a pattern, which suggests a continued downside. On a one-year chart, prices will appear to be oversold, and prices consolidate in the short term. Based on these metrics, a calendar spread would be a good fit. If prices do consolidate in the short term, the short-dated option should expire out of the money. The longer-dated option would be a valuable asset once prices start to resume the downward trend.
If stock XYZ is trading $105 and we buy a 100-strike price long calendar put spread that consists of selling a March call for $3 and purchasing a July call for $4.50, then our next cost would be $1.50 ($4.50-$3).
If the stock trades down to $101 at March expiration, the March puts would expire worthlessly, and the short March puts would get removed from our account. Now we are left with just the long July puts. If the stock traded down to $90 by July expiration, then we would profit $10 on the puts, but because we paid $1.50 for the position our profit would be $8.50. Consider this as if we only bought the July puts, to begin with (not selling March) our profit would have only been $5.50.
If the stock traded up to $120 by March expiration, the short-terms puts would expire worthlessly, but the longer-term July puts would be so far out of the money, they would have almost no value left. Here the investor could sell out of the positions for pennies or hope for a miracle. However, if the stock fails to reach $100, the longer-term puts would also go to zero, and the investor would lose his $1.50 investment.
If the stock traded down to $70 by March expiration, both sets of puts would be so far in the money, they would essentially have the same value, made up of entirely intrinsic value. So, the $1.50 paid for the position would be gone.
Analysis – Using the MarketXLS Template
This template can be used to analyze the profit from neutral stock price action at the strike price. It also helps in checking the limits on the risk in either direction of the strike price.
*Link to the template: https://marketxls.com/template/long-calendar-spread-with-puts-option-strategy/
Step 1: Open MS Excel with your MarketXLS subscription and enter the Stock ticker in cell E5.
Step 2: Mention the Strike price, short and long-term expiry of Put options in cells D13, D9, and D11 respectively. You can also specify the risk-free rate.
Step 3: Update the Plot Gap based on your requirement of the payoff profile.
*Output: The results will look somewhat as per images shown below,
It is recommended to execute a long calendar spread with puts if you expect a stock to trade lower, but that move will be in the future after the short-term puts have expired. A long calendar spread is a neutral trading strategy though, in some instances, it can be a directional trading strategy. It is used when a trader expects a gradual or sideways movement in the short term and has more direction bias over the life of the longer-dated option.
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