How to build a better Horizontal Calendar Spread Option Strategy?

calendar-spread-option-strategy

Know the tricky way to get maximum profit from Calendar Spread option Strategy

Horizontal Calendar spread option strategy is a very popular option strategy for generating regular monthly income. But sometimes the beginners face little bit problem in deciding which option to use to build the strategy; call or put?

In this article, I’ll clearly explain how to build up the most profitable horizontal calendar spread option strategy. Before comparing different types, let me explain the formation of horizontal calendar option spread strategy.

What is Horizontal Calendar Spread Option Strategy?

Calendar Spread is simply selling an option of the current month and buying a same type option of same strike price of the far month. The main goal of this strategy is to earn the premium of the near month short option after adjusting the time decay of the long option of far month.

Selling of near month option (Put/Call)
Buying of far month same type of option (i.e. call or put) of same strike price

Normally this is a neutral option strategy and used at the money options to build this strategy. But sometimes this strategy can be applied as slightly bullish and bearish way.

Calendar-spread-option-strategy

This is possible payoff diagram of a horizontal calendar spread strategy. This is not possible to correctly determine the perfect amount of maximum profit and break-even points in this strategy because of two different period options

What to use to form this strategy? Call or Put?

It’s a really big question. You are free to use any type of option (i.e. call or put) to build this strategy but there is some tricky techniques to get the effective one.

For more simplification, let me classify this horizontal calendar option strategy into three types:-

  1. Horizontal Neutral calendar spread
  2. Horizontal neutral to Bullish Calendar Spread
  3. Horizontal Neutral to Bearish Calendar Spread

As the names implies if the trader is fully neutral on the future movement of the underlying asset price then he should select the neutral calendar spread and he would select the other two if he has slightly bullish or bearish views on the underlying price respectively.

 

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Neutral Calendar Spread Neutral to Bullish Spread Neutral to Bearish Spread
Buy at the money call or put of far month and sell at the money call or put of near month.

 

As a rule the trader can build this strategy with any of the higher strike (more than the underlying current market price) call or put option but made this strategy with call option will be beneficial. Long one out of the money call option of far month and short one near month same strike call option. Like the previous one, the trader is free to build this strategy with any lower strike price (less than underlying current market price) call or put option but it is wiser to make this strategy with put options.
The trader should keep one thing in mind that if the actual stock price is little bit more than at the money strike price option, then he should use put options to made the strategy and vice versa. Why call options? Because , higher strike put option will be in the money options which will be costly .On the other hand, if the trade goes in favour of the trader, then the near month in the money put option will not expire worthless. So, the trader will actually earn a little profit or may incur loss. The reason behind such action is just like the previous one. Because the lower strike call options will be in the money call options whereas put options will be out of the money put options.
For example, the current price of stock A is $77. The trader wants to build a neutral calendar strategy using at the money options of strike price $75. Under such a situation, the cost will be less if the trader chooses the put options to build the strategy instead of call options. Because, here call options are currently slight in-the-money options, so maximum profit and maximum loss both will be high in case of strategy building from call option. For example, the current price of stock A is $77. The trader has a view that the stock price will not move downwards because there is a very strong support at $76 level. But the trader also not fully bullish on this stock because the current market situation.  He has a view that price may stay in between $76 to $.82 range. So he made the strategy with the call options of strike price of $80 e.g. Let assume that the current market price of stock A is $72 and there is strong resistance at $75 level. So, the trader has a view that the stock may move downwards but there is also 70% chance of the stock to stay range bound. So, the trader builds this neutral to bearish strategy with the put options of strike price of $70.

Hence, the main point behind such discussion is that the trader should build his option strategy with the out of the money options. Because the main aim of the trader in this strategy is to collect maximum premium from the short option after adjusting the time decay of the long one.

Now let me explain this with one example.

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Stock A was trading at $154.50 on 7th November’2017. The trader has a view that the stock may stay sideways or may  go little down in the near future, so he opt for the neutral to bearish strategy. Here, the at the money option strike price is $150 because there is $10 difference exists in two consecutive strike prices. Now he has two options to build this strategy as given below:-

Option1 Option2
Build this strategy with out of the money Put options Build this strategy with in the money call option
The trader sold $150 strike price November put @$4 per share and bought $150 strike price December Put @$7 per share. The trader sold $150 strike price November call option @$5 per share and bought $150 strike price December call option @ $8 per share.
Lot size is 100 shares Lot size is 100 shares.
Net debit=Long option-short option=7-4=$3 per share.

This is the possible maximum loss in this strategy.

Net Debit = Long option price-short option price= 8-5=$3 per share

This is the possible maximum loss in this strategy.

 

The prediction of the trader went right. The underlying stock prices moves down and expired at $151 level. The trader closed this option on the expiry.

Option1 Option2
Both the put options expired as out of the money options. Both the call options expired as in the money options.
The November month short put option expired worthless but the December month put option had the time value. The November month call option had only the intrinsic value but the December month call option had both the time and intrinsic value.
The November month put option expired with 0 price value and the December month put option expired at $4 price. This December premium value is the only time value. The November month call option expired at $1 and December month call option expired at $4.5 price value. Both the option premium value had intrinsic value.
Total Profit = profit from short option + loss from long option

=(-7+4)+(4-0)=$1 per share

Total Profit = profit from short option + loss from long option

=(5-1)+(-8+4.5)= $0.5 per share

 

Hence, if the trader opts for the first option then he would manage to get full time value of the short option and as a result he would get more profit.

 

Conclusion:

The trader is free to choose any type of option (i.e. call or put) while opening a horizontal calendar spread option but try to construct this strategy with out of the money options, it will be more profitable.

Happy Trading!

 

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About Moonmoon Biswas

Moonmoon Biswas is an Equity research analyst . She has more than 10 years of experience in this field. She has proven track record in the field of Technical analysis and the Fundamental analysis. From the educational background, She is an MBA-Finance with CFA (India). She has work experience in the leading broking houses in India and has also in hand experience in Australian Security Market. She has her own equity research firm and currently also engaged in digital marketing.

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