Option Strategies: The Calendar Spread

05/01/2012 3:55 pm EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

The calendar spread strategy works well amid low volatility, says Joe Kinahan, who discusses set-up, execution, and how best to manage the position once the trade is underway.

Our guest today is Joe Kinahan, and he is going to going to talk to us about calendar spreads.

Right now [Interview from early 2012 - Editor], we’re seeing the volatility level in the mid-17s, so we seem to be at the lower end of the volatility range that we’ve seen recently. One of the ways to take advantage of volatility when it’s at the lower end of the range is to buy calendar spreads.

A calendar spread involves the selling of a nearer-term option and the buying of a further-term option. To put it in more realistic numbers: Say we were trading a stock that’s trading at $25. It’s had a nice run up. You think the stock might sell off to perhaps $22 or so.

We’ll use March and April as our examples. You could sell the March 22 put and buy the April 22 put. A couple of things to think about if you do so: If the stock starts to come down towards your March 22 put, at March expiration, we go to $22 and that put is worth zero.

The April 22 at-the-money call and put have the most premium of any option out there. The spread starts to widen. Very nice way to take advantage of time decay because the option you sold decays at a faster rate than the option you bought and also gives you a chance to not necessarily lose a lot of money.

One of the important things to keep in mind in this trade is that it is not a home run trade. I always joke with people that I want to be Pete Rose without the gambling! Single, single, single...These are very nice single and perhaps double trades to take advantage of movement and take advantage of volatility. If volatility increases, it’s good for that further-term option you’ve bought.

When I’m doing these calendar spreads and it’s working in my favor, do I want to continue to work in my favor and just let everything expire, or should I close out the position?

That is a great point. One of the things that I see retail traders do too often is they think everything has to be an all-or-none. If you had two contracts, there is nothing wrong with taking one off and letting one go and putting a little bit of money in the bank.

Think in partials. Life is not all-or-none when it comes to trading. It’s a great point to bring up, and I would think people want to start taking that advice. Think about partials. If you take some off for a profit, you’ve lowered your cost basis and it can give you more patience with the rest of your trade.

Should I have a number in mind, saying “If I get to these numbers on the underlying and if I make this amount of profit, then I’m out?”

What ends up happening is as you become a little more experienced, you will start to see that. It’s why I always advise people to start with one or two contracts. Start really small. You can learn a lot from a small amount of contracts. There will be enough pain and suffering when you’re all for small amounts as compared to larger amounts.

Again, one of the things we see retail traders do too often is start big. It’s very easy to become a bigger trader once you have some success. It’s very difficult to start too big, lose money, and then make that up by overtrading.

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