Execute A Neutral Calendar Spread With Near Term & Longer Term Calls

Introduction To Neutral Calendar Spread

Execute A Neutral calendar spread

The neutral calendar spread involves selling near term calls and buying the same number of longer term calls. In the near term, the trader is neutral and predicts little to no volatility. When that happens, the near term options expire worthless and the trader gets to keep the premium collected from writing those options. In the longer term however, the trader predicts an upward bias to the price of the underlying security. All call options involved are derived from the same underlying security but have different expiration dates.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Neutral In The Short Term But Bullish In The Long Term
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss and risk
Step 7 : Limited profit potential
Step 8 : Calculate Risk & Reward Ratio
Step 9 : Set Up Trade :  Executing a neutral calendar spread strategy
Step 10 : Exit Trade
Step 11 : Record Trade In Diary

Step 1 : Perform economic, fundamental and technical analysis

A trader should perform economic analysis, fundamental analysis and technical analysis before executing a neutral calendar spread. The options trader should look out for chart patterns such as:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook – Neutral In The Short Term But Bullish In The Long Term

The trader is neutral in the short term. He sells near term options to profit from time decay. The rate of time decay is greater for short term options than longer term options. Hence, the options trader hopes that these near term options expire worthless. For the longer term, the trader hopes that the price of the underlying security makes a large directional move upwards such that he can close out the long call at a profit. Also, the trader tries to take advantage of volatility skews by selling options with a higher implied volatility and buying options with lower implied volatility.

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Step 3 :Study the option chain

Examine the options chain to select a short term call and a longer term call to construct the neutral calendar spread.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

Since the options used in  calendar spread have different expiration dates and since the strategy is a bet on volatility, it is difficult to calculate the breakeven point. Use software to estimate the breakeven point of a neutral calendar spread.

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Step 5: Understand Your Profit Zones

Execute A Neutral calendar spread
After being able to estimate your breakeven point, you can understand where is your profit zone. The profit zone occurs between the breakeven points.

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Step 6 : Limited loss and risk

The losses are limited to the net debit paid to initiate the spread. The reason there is a net debit is because the longer term option’s premium is greater than the near term option’s premium. The maximum and limited loss occurs when the the price of the underlying security stays below the strike price of the written call till the expiration of the longer term call option.

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Step 7 : Limited profit potential

The neutral calendar spread’s risk and reward profile resemble that of a winged animal, or rather, an animal with wings. Due to the nature of the spread, the profit which is realizable is limited and is equal to the premiums collected from the sale of calls less the time decay experience by the longer term options. Since the written shorter term options experience a faster rate of time decay ( Option premium decreases at a rapid rate) than the long term options, the trader can stand to earn a profit from the different rates of time decay when he closes out the trade on or before expiration of the near term options.

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Step 8 : Calculate Risk & Reward Ratio

Next calculate the risk reward ratio(even if it is estimated) to find out the attractiveness of the trade. The trade must have an attractive risk and reward ratio.

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Step 9 : Set Up Trade :  Executing a neutral calendar spread strategy

To execute a neutral calendar spread, an options trader can sell 1 near term at the money call options and buy 1 longer term at the money call option derived from the same underlying security.

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Step 10 : Exit Trade

The best case scenario is where the short term call expires worthless and the price of the underlying security  increases significantly thereafter. When this happens, the options trader can exit on a sliding scale, gradually.

What to do when the written near term options expire worthless in a neutral calendar spread?

  • A trader can reassess the outlook of the underlying security. If it is likely to be significantly more volatile with an upward bias, the trader can choose to hold on to the long term call option to profit from upside moves of the underlying security.
  • If the trader believes that volatility continues to be low and that there will be no significant movement of the price of the underlying security, the trader can choose to write another near term call option. When the price of the underlying security stays below the strike price of the written call, the written call will expire worthless and the trader gets to keep the written premium. If volatility is projected to be low, he can choose to write another near term call option.
  • Last but not least, the trader could close out his trade and take whatever profit or loss that comes with the decision. He should do this especially if he feels there is no chance of the long call ending deep in the money.

Step 11 : Record Trade In Diary

Last but not least, record the trade in the diary. Include all possible details such as profit, loss and duration of trade. Find ways to fine tune the trading process.

Example Of A Neutral Calendar Spread

AAA Corp is trading at $50. A trader believes that the price of the security will not go above $50 in the near term but in a 2 months, AAA Corp will make an earnings announcement and he expects the dividend to be increased . Hence, he executes a neutral calendar spread by:

  • Selling 1 August 50 call @ $2.50
  • Buying 1 November 50 call @ $4.50

Hence, a net debit is created. That net debit is:

($4.50 – $2.50) x 100 = $200

The trader pays $200 excluding commissions to establish the neutral calendar spread.

On the expiration of the August 50 call, the price of AAA trades at $49.

The written August 50 call expires worthless and the trader gets to keep $250. If he sells to close the November 50 call @ $3.90, he makes a loss of $60. As a result, the trader’s net profit of the trade is $250 – $60 = $190 .

If the price of AAA goes to $25 and stays unchanged till expiration of the November call, both options will expire worthless as it becomes far out of the money. At $25, it no longer makes sense to write near term calls at a strike price of $50 as options at that strike price will be too cheap to collect a meaningful premium from. When the above happens, the maximum loss is equal to the net debit used to establish the neutral calendar spread.

Study Comparable Strategies : Bull call spread vs neutral calendar spread

A bull call spread is very similar to the neutral calendar spread but has a more bullish projection over the longer term, and hence, the use of out of the money call options.