Hey Traders,
When market conditions are volatile and uncertain …
Buying puts and calls is NOT the move.
By using spread trades, you can reduce the cost of your trades and your trading risk …
While fine-tuning how you profit, and increasing your odds of success!
Over the last few weeks we’ve talked a lot about the so-called “advanced” trades I like to use…
And today we’re going to take a look at another one.
By the end of this, hopefully you’ll feel ready to start taking on some spread trades yourself …
In which case, you should check this out.
Before you see the words “advanced trades” and “spreads” and immediately click away, there’s something you NEED to know.
“Advanced” and “complex” trades really aren’t any more difficult than regular trades.
You’re just making a few at once.
But your broker wants you to THINK these trades are too “difficult” or “risky” …
Because they don’t make as much money off of you when you do them.
In reality, once you have a basic understanding of these trades …
Plus, they’ll save YOU money, because you can cut down on your trade costs!
So if you haven’t yet, take a look at these basic primers on call and put spreads, and butterflies…
And let’s dive into a new “complex” spread …
That lets you use volatility to your advantage!
Long & Short Calendar Spreads
Calendar spreads are a bit more nuanced, and do require somewhat of a deeper understanding when it comes to the options pricing model, because you are trying to use implied volatility and time decay to your advantage, while expressing either a neutral, bullish, or bearish opinion on the direction of the underlying.
A calendar spread (you may also hear this called a “time spread” or “horizontal spread”) is buying a contract in one month, and selling a contract in another month.
Simple enough, right?
In a long calendar spread, you are selling a near-term contract, and buying a longer-term contract, both at the same strike. Typically, this will result in a net debit, so you are paying to make this trade.
By contrast, a short calendar spread involves buying near-term and selling longer-term (also using the same strike for both contracts), and this is typically done for a credit.
With a calendar spread, you can express a neutral, bearish, or bullish position, but what you are really expressing is that you think the implied volatility (IV) of one month is mispriced against another month.
In a long calendar spread, you are essentially saying you think the front-month option is priced too high, while the longer-out option is priced too low.
Many traders use these trades when they think movement in the underlying stock will be neutral, but you can also construct them to benefit from moves higher or lower by adjusting your strike price, and using calls or puts.
Let’s say you think that there is currently too much implied volatility being priced into Month A, or you think there is not enough implied volatility being priced into Month B, making Month A too expensive and Month B too cheap (we’ll look at an example to illustrate this in a minute).
So you sell Month A and buy Month B.
What you hope will happen is that as Month A nears expiration, you will be able to buy back the contract for a lower price than you sold it (thus allowing you to profit), as the option loses value thanks to time decay.
Meanwhile, you are also hoping that the implied volatility (IV) increases, which will boost the value of your longer-dated option, which is not losing as much value due to time decay, as there is still adequate time value remaining. This helps negate time decay, and thus minimizing any loss in value.
Alternatively, you can hold Month A through expiration, when it will (ideally) expire worthless.
This means you are now long Month B at a reduced cost, thanks to the premium received from selling in Month A.
If you are neutral on the stock’s movement, you may want to target at-the-money options, since you believe the stock will more or less trade sideways during the time you are trading.
Or if you are bullish, you can construct this trade with out-of-the-money calls, and if you are bearish, you would go for out-of-the-money puts.
But the true star of the show is the implied volatility!
Our Capitol Gains traders recently closed out a 46% win on Exxon Mobil (Ticker: XOM) call calendars.
They opened this trade to sell April, while buying the May term (which happens to be when XOM will report earnings).
The sentiment here was that the current Russia crisis had inflated the implied volatility in XOM, though the actual anticipated oil crisis had not yet materialized.
Thus there was excessive IV being priced into the April term, especially when compared to the May term.
On the flip side, with a short calendar spread, you are buying the near-term month and selling the longer-dated month, usually allowing you to collect a credit.
This is when you think the near-term option is too cheap, while the long-term one is more expensive.
Rather than wanting the underlying to sit still in the near-term, this trader expects to see more movement soon, while movement (or implied volatility) falls in the longer-term, reducing the value of the sold option.
A calendar spread involving different strikes is called a diagonal spread. A diagonal spread typically expresses a stronger directional opinion than a calendar spread, which is typically more neutral (though like I mentioned, you can give calendars a directional tilt by choosing calls versus puts, and at-the-money versus out-of-the-money options).
Yes, calendars are perhaps a bit more complex than, say, a regular call spread, or even a butterfly.
But they can be excellent trading tools as you become familiar with options pricing, and when you know how to spot where implied volatility is too high or too low.
I plan to use calendar spreads – among other spreads – in my new Nitro Trader program.
If you’re interested in reaping the benefits of spreads, but aren’t sure where to start …
Nitro Trader is where you want to be.
Your Only Option,
Mark Sebastian