Calendar Put Spread

The Calendar Put Spread Setup

Let’s say you’re interested in ABC Inc., which is trading at $50 per share. You might set up a calendar put spread by:

1. Purchasing a long-term put option, having a strike price of $50 and is due to expire in six months, for a premium of $4.
2. Sell a short-term put option having the same strike price of $50 but that expires in a month, where you receive the premium of $1.

Who Should Invest In It

This strategy is suitable for traders who expect the stock price to be relatively stable in the near term but with a slight bearish bias over the longer term. It’s particularly attractive in environments where the short-term outlook is stable but uncertainty or potential declines could occur as the longer-dated option nears its expiration.

Strategy Explained

In a calendar put spread, the trader takes advantage of the faster time decay of the short-term option sold than the long-term option bought. This strategy is profitable if the stock price remains near the strike price at the expiration of the short-term put, which allows it to expire worthless or be repurchased at a lower cost, maximizing the initial credit received.

Breakeven Process

The breakeven point is variable for a calendar put spread since it hinges upon the remainder of the value left in the long put following expiration or closeout of the short put. The sweet spot happens when the passing time costs from the long put are exactly countered by the amount of money one earns in the sale of the short put.

Sweet Spot

The best-case calendar put spread will be when the stock price drifts close to the strike at expiration of the short-term put. This then allows the trader to either potentially buy back the short put cheaper or allow the short put to expire worthless but still hold on to the long put for its future price move.

Max Profit Potential

The maximum profit is theoretically uncapped if the stock price declines significantly after the short-term put expires, as the long put increases in value. However, practical maximum profit is usually limited and occurs when the stock price is just below the strike at the short put’s expiration.

Max Loss

The maximum loss is capped at the net cost of the spread at entry-the amount paid to enter the position. This happens if the stock price is above the strike price at expiration of the long put, so both options are worthless.

Risk

It is the case where the stock price rises dramatically beyond the strike. Under this scenario, the strategy becomes less effective and may result in a complete loss of the premium received for the long put.

Time Decay

Time decay, or theta, is a significant factor in this strategy. Since the short-term put sold will decay faster than the long-term put bought, the position will benefit as time progresses, provided the stock remains near the strike price.

Implied Volatility

Changes in implied volatility can significantly impact this strategy. A rise in implied volatility could increase the value of both puts, but it generally benefits the longer-dated put more, potentially increasing the overall value of the position. Conversely, a decline in volatility could decrease the value of the position, particularly if it impacts the long put more severely.

Conclusion

A calendar spread is a subtle strategy, best used in stable market conditions with expectations of increasing volatility or slight downward movements in the longer term. This strategy offers a favorable risk-reward balance since it limits the potential losses and allows for adjustments based on the market movements and changes in volatility.