A short calendar spread with puts is a possible strategy choice when the forecast is for a big stock price change but the direction of the change is uncertain. Short calendar spreads with puts are often established before earnings reports, before new product introductions and before FDA announcements. These are typical of situations in which “good news” could send a stock price sharply higher, or “bad news” could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in stock price and, as a result, the price of the short calendar spread increases and a loss is incurred.
It is important to remember that the prices of options – and therefore the prices of calendar spreads – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that sellers of calendar spreads believe that the market consensus is “too low” and that the stock price will move beyond a breakeven point – either up or down.
The same logic applies to options prices before earnings reports and other such announcements. Dates of announcements of important information are generally publicized in advanced and are well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts and calendar spreads adjust prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”
An increase in implied volatility increases the risk of trading options. For sellers of calendar spreads, higher implied volatility means that breakeven points are farther apart and that the underlying stock price has to move further to achieve breakeven.
“Selling a calendar spread” is intuitively appealing, because “you can make money if the stock price rises or falls.” The reality is that the market is often “efficient,” which means that prices of calendar spreads frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that selling a calendar spread, like all trading decisions, is subjective and requires good timing for both the position entry decision and the exit decision.
Put calendar spreads consist of two put options. A short put option is sold, and a long put option is purchased at the same strike price but with a later expiration date than the short put. A put calendar spread looks to capitalize on minimal price movement and time decay in the near-term put option and rising volatility in the long-term put option. The strategy is successful if the underlying stock price stays at or above the strike price of the short put before the front-month expiration, then moves below the strike price of the back-month long put option, preferably with increasing volatility. A debit will be paid to enter the position because the longer-dated option will be more expensive. The initial cost to enter the trade is the maximum loss at the front-month expiration.
A put calendar spread is purchased when an investor believes the stock price will be neutral or slightly bullish short-term. The position would then benefit from a decrease in price and increasing volatility after the short-term contract expires and before the longer-dated contract is closed. A more neutral outlook is typically expressed with a call calendar spread than a put calendar spread because of the greater time value inherent in call options relative to put options. The position has a maximum loss defined by the cost to enter the trade. If the underlying stock price is below the short put at expiration, the long put may be exercised to cancel out the assignment of the long shares. The position would then be closed for a max loss.
Ideally, the stock price is at or just above the short put at the time of expiration, and the short contract would expire worthless. A decision will then need to be made to either exit the long put position or wait to see if the stock price declines and/or implied volatility increases before the second expiration date. The further out-of-the-money the strike prices are at trade entry, the more bearish the outlook on the underlying security.
A put calendar spread is created by selling-to-open (STO) a short-term put option and buying-to-open (BTO) a put option with a later expiration date. Both put options will have the same strike price. Long put calendar spreads will require paying a debit at entry.
The initial cost is the maximum risk for the trade if the short put option is in-the-money and/or both options are closed at the front-month expiration. The profit potential is unlimited if the short put expires worthless, and the underlying stock price declines and/or implied volatility has a significant increase.
The payoff diagram for a put calendar spread is variable and has many different outcomes depending on when the options trader decides to exit the position. The maximum risk is defined at entry by the debit paid to enter the spread if both options are exited at the first expiration.
If the stock price is below the put options’ strike at the front-month expiration and the investor chooses to close both options, the loss would be the trade’s initial cost. If the stock price is above the short put strike at expiration--which is the goal of the calendar spread--the short contract will expire worthless. The long put option will still have extrinsic time value remaining. The investor can choose to exit the long put at this point or continue to hold the position with no increased risk.
At the near-term expiration, the payoff diagram slightly resembles an inverted V. After the near-term expiration, if the long put option is held, the payoff diagram is the same as a long put. If the stock price falls and/or implied volatility increases before the long put’s expiration date, the position will gain value. If the stock price rises, the extrinsic value of the long put will decrease.
For example, suppose a stock is trading at or above $50, and an investor believes the stock will stay above $50 before the first expiration. In that case, a put calendar spread could be entered by selling a $50 put option and purchasing a $50 put option with a later expiration date. Assume the short put was sold for $2.00, and the long put was purchased for $4.00. The initial debit of -$2.00 would be the maximum loss at the first expiration if both options are closed. If the short put is out-of-the-money at expiration, it will expire worthless, and the long call could be sold for its extrinsic value. The payoff diagram below illustrates a $100 profit as the outcome with the underlying stock trading at-the-money at the first expiration if the long put is sold with $3.00 of extrinsic value remaining.
However, the long put’s value may increase or decrease after the first expiration, depending on the price movement of the underlying security. If the short put is in-the-money at the first expiration and the long put is not sold simultaneously, the maximum risk may exceed -$200 if the stock subsequently reverses before the second expiration.
A put calendar spread consists of selling-to-open (STO) a short put option and buying-to-open (BTO) a long put option at the same strike price but with a later expiration date.
For example, if a stock is trading at or above $50, and an investor believes the stock will stay above $50 in the near future, a put calendar spread could be entered by selling a short-term $50 put option and purchasing a $50 put option with a later expiration date. The long put contract will have a higher premium because it has more extrinsic time value, so the position will cost money to enter. The debit paid will be the maximum risk for the trade at the expiration of the first contract.
The farther out-of-the-money the strike prices are at trade entry, the more bearish the outlook on the underlying’s price.
The decision to exit a put calendar spread will depend on the underlying asset’s price at the short put contract’s expiration. If the stock price is above the short put, the option will expire worthless. The long put option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock price.
Time value, or theta, works against the long option, and the contract will lose value exponentially as it approaches expiration. A sell-to-close (STC) order will be entered when the investor wishes to exit the position. The credit received when selling the long option, minus the original debit paid, will result in a profit or loss. If the underlying stock price is below the short put at the first expiration date, both options may be closed to exit the position. This will result in the maximum loss on the trade.
If the investor chooses only to close the in-the-money short put option, there is potential for more risk. The stock could reverse, and the long put option will lose value. However, if the stock price were to decrease, a larger profit could be realized. Legging out of a put calendar spread can increase the risk beyond the initial debit paid but creates the highest profit potential.
Time decay, or theta, will positively impact the front-month short put option and negatively impact the back-month long put option of a put calendar spread. Typically, the goal is for the short put option to expire out-of-the-money. If the stock price is above the short put at expiration, the contract will expire worthless. The passage of time will help reduce the short put option’s time value prior to expiration.
The time decay impact on the back-month option is not as significant early in the trade, but the theta value will increase rapidly as the second expiration approaches. This may influence the decision to exit the position.
Implied volatility has a mixed effect on put calendar spreads. Generally, put calendar spreads benefit from an increase in implied volatility. Ideally, the front-month short put option will expire out-of-the-money and be unaffected by changes in implied volatility. The position will experience the most profit if volatility is higher at the time of the second expiration. However, the stock price will need to be above the options’ strike price at the first expiration for the put calendar spread to be successful.
If implied volatility increases significantly early in the near-term expiration, the spread between the two contracts will decline. After the near-term expiration, the more implied volatility, the better. Higher implied volatility means there is a greater expectation of a large price change which is ideal for the remaining long put position. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.
Put calendar spreads can be adjusted during the trade to increase credit. If the underlying stock price rises rapidly before the first expiration date, the short put option can be purchased and sold at a higher strike closer to the stock price to receive additional credit.
For example, if a put calendar spread was entered at $50, and the underlying stock has increased to $60 before the first expiration, the short put could be bought back and resold at $55. This will collect more premium to help offset the initial debit paid, but if the stock reverses, the risk will increase to at least $5.00, the adjusted spread width between the strikes of the near-term expiration contract and long-term expiration contract.
If the underlying stock fails to challenge the strike price before expiration, the spread value has typically widened, allowing the position to be closed for a small profit, and no adjustment is necessary.
The short put option of a put calendar spread can be rolled higher if the underlying stock price rises. The short put may be purchased and resold at a higher strike price to collect more credit and increase profit potential. Ideally, the stock still closes above the short option, so it expires worthless. The long put option may have extrinsic value remaining to help reduce the loss or potentially make a profit.
Put calendar spreads are not typically hedged. The strategy has a specific goal and defined risk. The position can be adjusted higher if the underlying stock price increases. The put calendar spread holder may do nothing and continue to hold the position, allowing the near-term contract to expire worthless, and see if the underlying security reverses during the longer-term expiration.
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