Calendar Put Spread

The Calendar Put Spread, also known as a time spread or horizontal put spread, is an options trading strategy that involves the simultaneous purchase of a put option and the sale of another put option with the same strike price but different expiration dates. This strategy is designed to capitalize on the differing rates of time decay between the options and is often employed when the trader expects the underlying asset to exhibit low to moderate volatility.

The Setup

Consider a scenario where you're eyeing ABC Inc., currently trading at $50 per share. You might set up a calendar put spread by:

Buying a long-term put option with a strike price of $50 expiring in six months for a premium of $4.
Selling a short-term put option with the same strike price of $50 but expiring in one month, for which you receive a premium of $1.

Who Should Consider It

This strategy is suitable for traders who expect the stock price to be relatively stable in the near term, 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 benefits from the accelerated time decay of the shorter-dated option sold compared to the longer-dated option bought. This strategy is advantageous if the stock price remains near the strike price at the expiration of the short-term put, allowing it to expire worthless or be repurchased at a reduced cost, maximizing the initial credit received.

Breakeven Process

The breakeven point for a calendar put spread is not fixed and depends on the remaining value of the long put after the short put expires or is closed. It generally occurs when the loss due to the passage of time on the long put is offset by the premium earned from selling the short put.

Sweet Spot

The optimal scenario for a calendar put spread occurs when the stock price hovers near the strike price as the short-term put approaches expiration. This position allows the trader to potentially repurchase the short put at a lower price or let it expire worthless while still holding the long put for future price movements.

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 limited to the initial net cost of the spread—the amount paid to enter the position. This occurs if the stock price is above the strike price at the expiration of the long put, rendering both options worthless.

Risk

The main risk involves the stock price moving significantly above the strike price, which would decrease the effectiveness of the strategy and potentially lead to a total loss of the premium paid for the long put.

Time Decay

Time decay (theta) plays a critical role in this strategy. Since the short-term put sold will decay faster than the long-term put bought, the position benefits 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 put spread is a nuanced strategy best used in stable market environments with expectations of increasing volatility or slight downward movements in the longer term. It offers a favorable risk-reward balance by limiting potential losses and allowing for adjustments based on market movements and volatility changes.