According to tastytrade, a long calendar spread is, “a low-risk, directionally neutral strategy that profits from the passage of time and/or an increase in implied volatility.” In this process, you buy long-term stocks while selling an equivalent number of shorter-term stakes. The process can be done through inputs or calls and becomes equivalent if using the same strikes and aspirations. Using At The Money (ATM) strikes makes it neutral while using Out Of The Money (OTM) or In The Money (ITM) turns the process biased.
There are two ways in which calendar trade makes money. One is Time decay, where the short term option loses more value than the long term trading. The trader has to balance both processes to gain profits. Volatility change is the second process, which involves balancing an increase in Volatility in long term trades and reduced Volatility in short term trades to achieve value.
Essential things to know about trading calendar spreads
Here are some tips you need to know about trading spreads:
- Always pick Expiration months for a covered call: This trading strategy matches a covered call, only that you don’t possess the underlying stock, but still, you have a right to purchase it. Through this trading, you can quickly pick expiration months. It’s advisable to go for at least two months, following the forecast. If trading on short strike, choose the shortest dated option since it loses value fast and rolls out from one month to the next.
- Leg into the spreads: Traders owning calls can sell options against this position and combine multiple options into a calendar spread at any given point. Traders can sell calls against the stock if neutral for the short term. Legging can be a strategy to override the dips in upward trending stock.
- Have a Plan to manage risks: Traders need to plan their managing risks while trading in calendars. They should try to cut costs when they find out that the trade isn’t falling to what they focused on.
- Check on the Profit and Loss graph before trading: Traders should use the broker tools or free software to determine the trade’s profit and loss before engaging in calendar trades to maximize their profits and avoid trading losses.
- Don’t trade on Dividends date: Dividend dates are when companies declare their dividends to the shareholders. Traders should avoid trading at this time to avoid losing the bonuses.
- Don’t trade through major news: Traders should avoid trading on significant news dates such as earnings announcements unless they want to take advantage of the inflated IV of the month ahead. Such dates tend to have losses to traders.
- Have an exit plan before trading: One should put their profit target and loss before getting into the calendar trade. Traders should have an exit plan in case any of these comes first. One should open up a new trading calendar once they reach the breaking point.
Calendar spreads trading acts as a directional trading strategy, if not a neutral trading strategy because it helps traders stay afloat in short-term trading and the longer-dated trading option. Traders need to embrace the implied volatility technique to save money.