Calendar Spread for the Market Neutral Trader

The Ordinary Calendar Spread

Close-Up Of Calendar Date
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In our introduction to the calendar spread, the idea of buying out-of-the-money calendar spreads as a directional play was introduced. Before going there, let's look at the market-neutral calendar.

Let's Assume  

  • You are interested in taking a position in XYZ.
  • Current stock price is $62 per share.
  • Current implied volatility (IV) is near its historical level. 
  • Date: August expiration arrives in 25 days; September expiration is 28 days later.

    Calendar spread for a market-neutral bias

    Traders who anticipate that XYZ will still be trading near its current level as expiration of the August options approaches, can earn a profit if that expectation comes true. 

    In this example, you can buy either

    XYZ Sep/Aug 60 call spread  or the

    XYZ Sep/Aug 65 call spread 

    If the days pass and XYZ remains near its current level, then the Aug 60 (or Aug 65) call loses value faster than its September counterpart. As a result, the spread gains value.  At some point, you can exit the position and take the profit.

    If you are new to this strategy, my recommendation is to make a that seeks a specific profit target. Although you can use a calculator to come up with a scenario to get an estimate of the spread's value at that future time, it is far easier to use your broker's risk management software. Set the date two weeks in the future and get a feel for both the profit potential and the risk associated with holding the spread.

    The reward for this strategy is often not large in dollar terms, but the return on investment (ROI) can be quite substantial.

    In reality, most inexperienced traders don't think in terms of profit taking. They have a tendency to hold the trade until expiration arrives for two reasons:

    • They hope to earn the maximum possible profit.
    • They don't understand how and why to let go of a winning position. This is a future topic for discussion.

    I encourage you to establish some target profit for each trade and to accept that profit when it becomes available. This is an important part of any risk-management program. 

    The problem with having a neutral opinion on the stock is that the calendar costs the most when the stock is near the strike. That makes it costly to buy an ATM calendar spread.  There are other market-neutral strategies from which to choose. However, when you believe that the stock price will remain essentially unchanged from the time you make the trade until near the expiration date of the shorter-term option, then the ATM calendar spread is an attractive choice.

    I urge you to avoid the ATM calendar unless you believe that implied volatility will increase over the lifetime of your trade (see below). 

    Vega

    Vega is the component of an option's value that is affected by a change in the option's implied volatility. Vega is one of "the Greeks."

    The calendar spread is long Vega (i.e., the position has positive Vega).  That means the spread performs better (larger profit or reduced loss) when implied volatility increases during the time that you own the position, and loses money when implied volatility decreases.

    I suggest avoiding calendar spreads when you doubt that IV will increase while you own the position. 

    Do not force a market-neutral calendar spread into your portfolio. Make this play only when the implied volatility is low enough that it probably will not decline -- and has a significant chance of rising while you own the position.