How to Trade Options - Calendar Spreads

Using Expiration and Neutral Market Movement to your Advantage with a High Probability Trade

Calendar spreads are a simple and widely recommended ingredient for any option trader's portfolio. The mindset behind this sort of diversification is that one needs a strategy to make money in any kind of market, whether the market goes up, down or sideways. There are plenty of simple strategies for when the market goes up and down, but sideways is usually a bit trickier and less well known. That's where calendar spreads become so useful.

Grow Calendar 2011

A calendar spread consists of buying a LEAP call one or two strikes out of the money, then selling a front month option at the same strike price. Calendar spreads work by manipulating the time decay value on options in favor of your spread and against the option you are selling. Since around 80 percent of all options typically expire worthless without going into the money, it pays to play a spread that profits from that expiration.

As was previously mentioned, calendar spreads are a neutral options trade. They rely on the underlying remaining at or around the strike price that was originally purchased on both options. Assuming it remains around the same strike price until expiration, what will happen is the front month option will lose all of its value, having expired out of the money, whereas the leap option that you originally purchased will have retained the majority of its value since its value is still primarily defined by the time it has until expiration.

So in essence, this trading strategy allows you to buy option time at a wholesale price and sell it back to a speculator at a retail price in this option strategy. Options experience the most dramatic reduction in value in the front month, so the premiums you collect will no doubt pay a higher value than the long term options you are buying to cover yourself in case you are exercised or have to buy back your option trade.

When trading a calendar spread, I recommend looking for the following indicators before entering the trade:

1. Relative Strength Index between 30 and 70 for the past 2 to 3 months. Any extreme upheavals or signs of volatility are a bad sign for playing a calendar spread. Look for a stock that has a controlled RSI for the past several months and no significant breakouts of momentum in either direction.

2. Range bound price action for the past 2 to 3 months. If you can fit the price action of a stock for an options trade into a box with the price bouncing off the upper and lower edges of the box, then you have a stable enough stock to place a calendar spread on. Look closely for any Bollinger band breakouts or unusual rises in the stochastic to help confirm this.

3. No historic signs of gapping. If this is an asset that gaps every single time an earnings report is released, then you want to avoid it altogether unless you know the calendar well enough to determine that any game changing fundamentals are beyond the reach of your options trade.

4. Implied volatility below.8. Typically, implied volatility measures the expected range of price action in the future with 1 being the average of all assets within the market. Your calendar spread should be placed on an underlying that has a reasonably low implied volatility well below the market average. High volatility could threaten your spread and cause you to lose money, so just be aware and avoid this particular pitfall.

How to Trade Options - Calendar Spreads

Grow Calendar 2011