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Calendar spreads are an option trade that involves selling a short-term option and buying a longer-term option with the same strike.
Traders can use calls or puts and they can be set up to be neutral, bullish or bearish with neutral being the most common.
When doing bullish calendar spreads, we typically use calls to minimize the assignment risk. Likewise, if the calendar is set up with a bearish bias, we use puts.
Neutral calendars can use calls or puts, but calls are more common.
Let’s look at a couple of examples, using Walmart (WMT), JP Morgan (JPM), and Exxon Mobil (XOM)
WMT Neutral Calendar Spread
Let’s use WMT stock for our first calendar spread example.
With Walmart stock trading around 120, setting up a calendar spread at 120 gives the trade a neutral outlook.
Selling the June 17 call option with a strike price of 120 will generate around $230 in premium, and buying the July 15, 120 call will cost approximately $420.
That results in a net cost for the trade of $190 per spread, and that is the most the trade can lose.
The estimated maximum profit is $150, but that could vary depending on changes in implied volatility.
The idea with the trade is that if WMT stock remains around 120 for the next few weeks, the sold option will decay faster than the bought option allowing the trade to be closed for a profit.
The breakeven prices for the trade are estimated at around 117 and 123.50, but these can also change slightly depending on changes in implied volatility.
In terms of trade management if WMT broke through either 115 or 125, I would look to adjust or close the trade.
Let’s look at another example.
JPM Neutral Calendar Spread
With JP Morgan stock trading around 125, setting up a calendar spread at 125 gives the trade a neutral outlook.
This trade idea is slightly longer-term than the previous example.
Selling the July 15 call option with a strike price of 125 will generate around $495 in premium, and buying the September 16, 125 call will cost approximately $790.
That results in a net cost for the trade of $295 per spread, and that is the most the trade can lose.
The estimated maximum profit is $365, but that could vary depending on changes in implied volatility.
The idea with the trade is that if JPM stock remains around 125 for the next few weeks, the sold option will decay faster than the bought option allowing the trade to be closed for a profit.
The breakeven prices for the trade are estimated at around 116 and 136, but these can also change slightly depending on changes in implied volatility.
In terms of trade management if JPM broke through either 116 or 136, I would look to adjust or close the trade.
Let’s look at our last example.
XOM Neutral Calendar Spread
With Exxon Mobil stock trading around 100, setting up a calendar spread at 100 gives the trade a neutral outlook.
Selling the July 15 call option with a strike price of 100 will generate around $550 in premium, and buying the August 19, 100 call will cost approximately $730.
That results in a net cost for the trade of $180 per spread, and that is the most the trade can lose.
The estimated maximum profit is $240, but that could vary depending on changes in implied volatility.
The idea with the trade is that if XOM stock remains around 100 for the next few weeks, the sold option will decay faster than the bought option allowing the trade to be closed for a profit.
The breakeven prices for the trade are estimated at around 94 and 107, but these can also change slightly depending on changes in implied volatility.
In terms of trade management if XOM broke through either 94 or 107, I would look to adjust or close the trade.
Mitigating Risk
Thankfully, calendar spreads are risk defined trades, so they have some build in risk management. Position sizing is crucial to ensure that minimal damage is done if the trade suffers a full loss.
One way to set a stop loss for a calendar spread is close the trade if the loss is 20-30% of the premium received.
Calendar spreads can also contain early assignment risk, so be mindful of that if the stock breaks through the short strike and its getting close to expiry.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
*Disclaimer: On the date of publication, Steven Baster did not have (either directly or indirectly) positions in some of the securities mentioned in this article. All information and data in this article is solely for informational purposes. Data as of after-hours, June 9, 2022.