A calendar spread is a derivatives strategy involving purchasing longer term options and selling shorter term options of the same underlying asset. In fact, according to tastytrade, “a calendar is comprised of a short option (call or put) in a near-term expiration cycle, and a long option (call or put) in a longer-term expiration cycle. Both options are of the same type and use the same strike price.”
For those who invest in the stock market and want to improve their financial status, the calendar spread can certainly be used to make money, and this is done through two ways. The first way a calendar spread makes money is through time decay where the short term option is losing value at a much faster rate than the back month option. The second way the calendar spread makes money is through an increase in volatility in the long term option or a decrease in volatility of the short term option. That being said, there are certain guidelines or rules that individuals investing in the stock market should know. These trading calendar spreads rules are presented in the following article.
Rules trading calendar spreads:
Individuals who invest in the stock market should certainly avoid trading through dividends dates.
Individuals should also always check the P/L graph before deciding to place a trade. This can be done via a free software or with the help of broker tools.
People who invest in the stock market should avoid trading through important news, such as earnings announcements.
The short term option should expire in 5 to 7 weeks.
Individuals should also have an exit plan before they enter the trade.
It is also imperative that individuals investing in the stock market to never hold through the expiration of the near month, which is the nearest expiration date of a futures contract, in order to avoid the gamma risk.
In addition to the above, people should also open another calendar spread in case the stock reaches a break-even point. This is a case of a double calendar where the second calendar is around the current price.
People who invest in the stock market should also trade stocks that have a positive volatility skew.
Another imperative guideline would be placing the trade with puts rather than with calls as it is considered a cheaper route.
To sum things up, when an individual who buys and sells stocks purchases a calendar spread, which means purchasing a long term option and selling a short term option of the same strike price and type, he or she is predicting that the stock price will trade near the strike price as time goes by. The trader can certainly generate profit if the stock price lingers around the strike price of the long calendar over the course of time, which means that the near term or short option decays at a faster rate than the long term or far option and the calendar’s price will witness an increase.