Options are a useful tool for investors during a collapse in market conditions. The thought of options makes some investors tremble, but numerous option strategies are available to lower the market volatility’s risk. One great strategy that can be used in every market environment is calendar spread. Futures and options traders primarily use calendar spread. However, it is only advantageous when a day trader anticipates that the derivative will have a price trend from neutral to moderate rising.

A calendar spread is a low-risk strategy where you expect to profit from the passage of time along with the expected volatility of derivatives. As the expiration date of the first-month option approaches, the option prices begin to decline.

What is Calendar Spread?

A calendar spread is a futures strategy or market-neutral option that involves buying and selling the same option, either calls or puts, for the same underlying asset at the same strike price but with different expiration dates. In a regular calendar spread strategy, one would buy a longer-dated call option and sell a short-dated call option that is of the same strike price. However, if two different prices are used, it refers to a diagonal spread. Calendar spreads are also known as horizontal spread and time spread.

Moreover, this strategy is for experienced and knowledgeable traders. The benefits of spreads and option tradings can be combined in a single position by using calendar spreads. Technically, the calendar spread provides traders an opportunity to trade at different levels of volatility skew to take advantage of the acceleration of time decay or theta. In addition, they also have a chance to limit the exposure impact on the derivatives price. An investor can assume one of these two things, depending on how they implement their strategy.

Long Calendar Spreads

A long calendar spread or time spread is established by simultaneously buying and selling a call or put options within the same price but with different expiration months.

In simple terms, if a trader buys a longer-term option and sells a short-term option, a trader’s account will be debited consequently. Selling the short-term option lowers the price of a long-term option, which will make the trading more affordable than outright purchasing the long-term option. Since the two options have different expiration months, this trade can change significantly as expiration months go by.

Furthermore, a long calendar spread is the best strategy to employ when you predict that the price will be close to the strike price when the front-month option expires. It is perfect for traders whose short-term outlook is neutral. Also, the short-term option should ideally expire in the red. As a result of this, a trader will be left with a long position.

In contrast, if the trader’s prediction is still neutral, they may sell an additional option in opposition to their long position, resulting in another spread. Conversely, the trader can keep the long position open and enjoy the advantages of having ongoing profit potential if they now believe the stock will move in a longer-term forecast direction.

Planning the Trade

Recognizing market sentiments and analyzing market conditions for the upcoming few months is the first and foremost step in the trading strategy. Suppose a trader has an unfavorable outlook on the market, and the overall mood shows no signs of changing anytime soon. In this situation, a trader should consider using a put calendar spread.

This method can be used on any exchange-traded fund, stock, or index. However, a trader should opt for a liquid instrument with small spreads between ask & bid prices in order to achieve the greatest results. In addition, a trader should create an exit strategy and effectively manage the risk. Although proper position size will assist in risk management, a trader ought to ensure they have an exit plan in mind before entering the trade.

Trading Tips

When trading a calendar spread, traders should consider the following trading tips.

Choose Expiration Months for Covered Call

Calendar spread trading should be viewed as a covered call strategy. However, the only thing that differs is that while the investor doesn’t actually own the underlying stock, they do have the right to purchase it. Hence, the trader is able to quickly choose the expiration months by treating calendar spread trade like a covered call.

Leg-into Calendar Spread

Traders who have puts or calls against a stock can sell an option against the position and leg-into a strategy at any time. For instance, if a trader has calls on a stock that recently leveled off after steadily rising to the upside. They can sell a call for this stock if they’re neutral over the shorter term. This legging-in strategy can help traders ride out dips in the upward-growing stock.

Plan for Risk Management

The last and crucial trading tip is about managing risk. When the trader is determined that the trade no longer fits within the scope of their prediction, they should aim to minimize losses by planning their position size according to the trade’s maximum loss.

Risks

In addition to benefits, traders should also be aware of the following risks associated with calendar spread trading.

Limited Upside Early on

Calendar trading has limited upsides in the early stages. However, after the expiration of the short option, the remaining long position has a lot of profit potential.

Recognize Expiration Dates

These dates imply another risk in trading, so a trader must be aware of expiration dates. A trader should take swift action when the short option’s expiration date draws near.

Make Timely Entry

Untimely entry is the last risk to avoid during calendar spreads trading. When trading spreads, market timing is far less crucial, yet poorly timed entry or trade can quickly result in a significant loss.

The Bottom Line

Although a long calendar spread can occasionally be a directional trading strategy, it is a neutral-trading strategy. This low-risk strategy is used when the trader forecasts a steady or sideways activity in the shorter term and has a stronger direction bias throughout the life of the longer-dated option.