When running a calendar spread with puts, you’re selling and buying a put with the same strike price, but the put you buy will have a later expiration date than the put you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) put as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term put for next to nothing. At the same time, you will sell the back-month put to close your position. Ideally, the back-month put will still have significant time value.
If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money puts. If you’re mildly bearish, use slightly out-of-the-money puts. This can give you a lower up-front cost.
Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value. You can only capture time value. However, as the puts get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.
For this Playbook, I’m using the example of a one-month calendar spread. But please note it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.
Maximum Potential Profit
Potential profit is limited to the premium received for the back-month put minus the cost to buy back the front-month put, minus the net debit paid to establish the position.
Maximum Potential Loss
Limited to the net debit paid to establish the trade.
NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on how the back-month put performs.
Break-even at Expiration
It is possible to approximate break-even points, but there are too many variables to give an exact formula.
Because there are two expiration dates for the options in a calendar spread, a pricing model must be used to “guesstimate” what the value of the back-month put will be when the front-month put expires. TradeKing’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required if the position is closed at expiration of the front-month option.
As Time Goes By
For this strategy, time decay is your friend. Because time decay accelerates close to expiration, the front-month put will lose value faster than the back-month put.
After the strategy is established, although you don’t want the stock to move much, you’re better off if implied volatility increases close to front-month expiration. That will cause the back-month put price to increase, while having little effect on the price of the front-month option. (Near expiration, there is hardly any time value for implied volatility to mess with.)