Here Are Some Ways We Can Utilize the Calendar Spreads to Grow a Small Account

Options are a crucial tool for investors when market conditions deteriorate. Some investors shudder at the thought of options, yet there are a variety of options methods available to assist mitigate market volatility risk. The calendar spread is a strategy that can be used in any market environment.

Calendar spreads are an excellent approach to combine the benefits of both spreads and directional options trades in one position. Investors can assume one of two outcomes depending on how they apply this strategy:

1. A market-neutral position that can be rolled out a few times to cover the spread cost while profiting from time decay.

2. A market-neutral short-term position with a longer-term directional bias and unlimited profit potential.

In either case, the trade can provide a number of benefits that a simple call or put cannot.

Long Calendar Spreads

The purchasing and selling of a call option or a put option with the same strike price but different expiration months is known as a long calendar spread (also known as a time spread).

In other words, if a trader sells a short-dated option and buys a longer-dated option, the account will be debited. The short-dated option is sold to lower the price of the long-dated option, making the deal cheaper than buying the long-dated option outright. Because the two options have distinct expiration months, this trade can take many different forms as the months pass.

Long calendar spreads are divided into two categories: call and put. Trading a put calendar has some advantages over trading a call calendar, but both are viable options. The attitude of the underlying investment vehicle determines whether a trader utilizes calls or puts. A bullish trader would purchase a calendar call spread. A bearish trader would purchase a calendar put spread.

If the trader's projection remains neutral, they can sell another option against the long position, legging into a new spread. If the trader now believes the stock will begin to move in the direction of the longer-term prognosis, the trader can keep the long position open and benefit from the unlimited profit potential.

Trade Preparation

Identifying market sentiment and a prognosis of market conditions over the next few months is the first stage in arranging a trade. Assume a trader has a gloomy opinion on the market and that mood is unlikely to change in the next months. A trader should consider a put calendar spread in this situation.

This approach can be used to invest in a company, an index, or an exchange-traded fund (ETF). However, a trader may want to pick a liquid vehicle with tight spreads between bid and ask prices for the greatest returns. We'll use the DIA, which is an ETF that tracks the Dow Jones Industrial Average, as an example.

Recent price activity on this five-year chart (Figure 1) reveals a reverse pattern known as the head-and-shoulders pattern. This pattern has been reinforced by prices, implying that the downtrend will continue.

Prices will appear to be oversold on a one-year chart, and prices will consolidate in the short term. A calendar spread would be a suitable fit based on these criteria. The short-dated option should expire out of the money if prices do consolidate in the immediate term. Once prices continue their downward path, the longer-dated option will be a great asset.

We examine at the values of the July and September 113 puts based on the price given in the DIA chart, which is $113.84. Here's how the trade works:

• Bought September DIA 113 puts: -$4.30

• Sold July DIA 113 puts: +$1.76

• Net debit: -$2.54

It's crucial to understand how the market will react when you first start trading. Because each position counters the other in the short term, spreads move more slowly than most option strategies. If DIA maintains over $113 at the end of July, the July option will expire worthless, leaving the investor with a September 113 put to trade. In this situation, the trader wants the market to move as far to the downside as possible. This transaction grows more profitable the faster it advances.

If prices fall below $113, the investor has the option to roll out the position, which entails buying back the July 113 put and selling an August 113 put. If the trader becomes progressively negative on the market at that time, the position might be converted to a long put.

The trader's final actions in this procedure are to create an exit strategy and effectively manage their risk. Position sizing is important for risk management, but traders should also consider their exit strategy before entering a trade. As things stand, the trade's maximum loss is a net debit of $2.54.

Tips

When trading calendar spreads, there are a few things to keep in mind.

Pick Expiration Months as for a Covered Call

When trading a calendar spread, it's best to think of it as a covered call. The main distinction is that the investor does not own the underlying stock, but does own the right to purchase it.

The trader can rapidly choose the expiration months by treating this deal like a covered call. A trader should select the expiration date of the long option at least two to three months in advance, based on their projection. When choosing a short strike, however, it is best to always sell the shortest-dated option available. These options depreciate the most quickly and can be rolled out month to month over the trade's life.

Leg Into a Calendar Spread

Traders who own calls or puts against a stock can sell an option against the position at any time and leg into a calendar spread. For example, if a trader owns calls on a stock that has recently steadied out after making a strong rise to the upside. If a trader is neutral in the short term, they can sell a call against this stock. This legging-in approach can be used by traders to ride out dips in an upward going stock.

Plan to Manage Risk

Risks

When both legs are in play, the upside of calendar trading is limited. The remaining long position, on the other hand, has an unlimited profit potential after the short option expires. It is a neutral trading approach in the early phases of this trade. If the stock begins to move faster than expected, the gains may be limited.

Be Aware of Expiration Dates

Expiration dates signify a different danger. As the short option's expiration date approaches, action is required. The contract is worthless if the short option expires out of the money (OTM). If the option is in the money, the trader should consider repurchasing it at market value. The trader can then select whether or not to roll the position after taking action with the short option.

Time an Entry Well

An late entrance is the final danger to avoid while trading calendar spreads. When trading spreads, market timing is less important, but an ill-timed move can quickly result in a maximum loss. A prudent trader examines the wider market to ensure that they are trading in the direction of the stock's fundamental trend.

Final Thoughts

We examine at the values of the July and September 113 puts based on the price given in the DIA chart, which is $113.84. Here's how the trade but has a stronger direction bias throughout the life of the longer-dated option, this strategy is used. A net debit is created by selling a short-dated option and buying a longer-dated option. This spread can be bullish or bearish because it can be formed with either calls or puts. The trader wishes for the short-dated option to expire sooner than the longer dated option.

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