4. Trading Options Based on the calendar, Practical implementation of Calendar Spread Strategy

Hello

Welcome to Tiger Academy - 「Options Advanced Strategy」episode 4.

Recently, I don't know what trend is happening, and everyone is beginning to advocate for the investment strategy of selling puts.

Tiger academy wants to tell everyone that while selling puts is indeed good, in the backdrop of a bull market in the U.S. stock market, sellers can collect time value, enjoy a high success rate, and stable income.

However, in the event of adverse movements such as a sharp drop in stock prices, sellers may incur significant losses. In other words, while earning theta income, sellers also face delta and gamma risks. Furthermore, being exclusively on the sell side can tie up a large amount of margin, resulting in high opportunity costs.

How can one both earn time value, hedge against adverse stock price movements, and use little to no margin? Today, we will introduce the calendar spread strategy, which can effectively achieve this!

1. What is the calendar spread strategy

The calendar spread strategy, to put it simply, involves timing the options market. We know that the decay rate of the time value of options is not a linear process but rather exhibits a characteristic of being slow in the early stages and faster in the later stages.

Therefore, while selling options expiring in the near term, we simultaneously buy options with the same strike price but expiring in the distant future – a strategy known as selling near and buying far. This allows us to profit from the difference in time value.

For example, let's consider a scenario where today is December 18th, and we are looking at a call option for Tesla with a strike price of $252.5. The theta value for the option expiring on December 22nd (4 days until expiration) is -0.577, while the theta value for the option expiring on December 29th (11 days until expiration) is -0.343. As we discussed in our previous article on 🎁Day 3.The longer the expiration date, the smaller the time value. Can you believe it? We explained the meaning of theta values in that article.

In other words, the time value decay of the former is $0.234 greater than that of the latter on the same day. The reason is that the former is closer to the expiration date, leading to an accelerated decay of time value, while the latter experiences relatively slower time value decay. Additionally, both options have identical delta values, so theoretically, the delta risk for both is the same.

If we sell a call option expiring on December 22nd, earning a premium of $6.35, and simultaneously buy a call option expiring on December 29th, incurring a cost of $8.5, the net premium outlay is $2.15.

Since both options have equal delta values, theoretically, there is no price change risk (assuming delta coefficients remain constant). Therefore, this strategy can generate positive time value income every day. By closing out both options on the near-term expiration date of December 22nd, we can realize a total time value difference of $2.15.

This is the key advantage of the calendar spread strategy: relative to buying strategies, it allows for time value income; compared to selling strategies, it mitigates price change risk without requiring a significant amount of margin (the margin requirement for the combination hedging strategy is quite low).

Of course, while this strategy is simple and effective, practical implementation should still consider the following issues.

2.What points should be noted in the calendar spread strategy?

1.Non-linear Changes in Delta Values

In our previous example, we assumed that the delta values of the two options remained equal. Although both options were at-the-money, due to unequal gamma values, a change in the underlying stock price could lead to differences in the delta values of the two options.

In such cases, there is no need to excessively worry about risk exposure because, even though the gamma values of options with the same strike price are not identical, the differences are not significant. Furthermore, the theta values of the two options will diverge further as the expiration date approaches, meaning that theta gains can completely offset the losses caused by delta differences.

Continuing with the previous example, on the second day (December 19th), we continue to observe the prices of the two options. We observe that due to a 0.56% decrease in Tesla's stock price, the price of the sold call option decreases to $7.05, and the price of the bought call option also decreases to $7.05. This results in a loss of $1.45 relative to the previous trading day (8.5 - 7.05).

As for the sold call option, its price dropped to $4.63, resulting in a profit of $1.72 compared to the previous trading day (6.35 - 4.63).

In the end, the calendar spread combination achieved a profit of $0.27 on the following day (1.72 - 1.45). And what factors contributed to this $0.27 profit? Let's break it down:

Due to the drop in stock price, the delta value of the sold call option changed to 0.5, while the delta value of the bought call option changed to 0.513, resulting in a delta loss of 0.013 for the combination.

As a day passed, the theta value of the bought call option became -0.620, while the theta value of the sold call option became -0.337, resulting in a theta gain of 0.283 (0.620 - 0.337) for the combination.

Therefore, after netting theta gains and delta losses, the combination yielded a profit of $0.27 (0.283 - 0.013).

2.Selection of Expiry Date and Strike Price

How should one choose the expiry date and strike price for a calendar spread? Regarding the selection of the expiry date, the greater the time difference between near-term and far-term contracts, the larger the theta gain. For beginners, it is recommended to maximize theta gains while controlling delta risk. Therefore, choosing two option contracts with similar deltas at the same strike price but with the maximum time difference is advisable for a calendar spread strategy.

As for the strike price, at-the-money options experience the fastest time value decay, with a higher theta coefficient. Therefore, for a calendar spread, at-the-money options tend to yield the best results. For experienced traders, if anticipating slight future stock price fluctuations, different strike prices can be chosen. Combining calendar spreads with bullish/bearish spreads, for example, selling near-term out-of-the-money call options (low delta, high theta) while simultaneously buying far-term in-the-money call options (high delta, low theta) can allow traders to earn both time value and delta gains.

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