- January 19, 2023
- Posted by: CoachShane
- Category: Trading Article
The trader who uses this strategy is looking for a stock price that will rise modestly during the life of the near-term option and then fall when the far-term option expires. On the other side of the coin, they hope for a significant increase in implied volatility levels.
Quick Takeaways
Here are 5 quick points about trading long put calendar spreads
What is a long put calendar spread?
A long put calendar spread is an option trading strategy that involves selling one near-term put and buying an equal number of further out-of-the money puts. This creates a position with limited risk and potential for profit if the stock price moves quickly in the desired direction.
How does a long put calendar spread work?
By selling one near-term put and simultaneously buying an equal number of further out-of-the money puts, the trader reduces their risk from unlimited to limited. This is because if the stock price falls enough that both puts are in the money, only the near-term put will be exercised and the further out-of-the money put will remain to provide a hedge.
What is the maximum risk when trading long put calendar spreads?
The most you can lose when implementing a long calendar spread with puts is the amount you spent on the spread, including commission costs. In our example, the most we can lose is $36.00.
When do you hit break-even with a long put calendar spread?
The long calendar spread with puts has two possible points at which you will hit the breakeven mark; these happen if the stock either has a sharp move higher or lower before the short-term put expires.
What are some scenarios that could occur when trading long put calendar spreads?
Some scenarios that could occur include the stock price falling enough that both puts become in-the money, the stock price rising to a point where the short-term put expires worthless and the longer term put is far out of the money, or the stock price falling after near month expiration. In any case, exercise risk is always present and should be taken into account when trading long calendar spreads.
SOUTHWEST AIRLINES CO (LUV) Example
SOUTHWEST was currently trading at $39.59 at the time of this post.
Imagine you are a little bullish in the short term and expect this stock to take a run-through current resistance. Slightly above this level is another resistance and you are expecting the price to be rejected and for LUV to head to the downside.
For the first put, we go out 21 days for the expiration date and sell a slightly out-of-the-money contract at the strike price of $39.00. Imagine we receive the ASK price and receive .97 or $97.00 in premium.
We need to buy a contract for the other half of this spread and for this, we head out 42 days to the $39.00 strike price.
For this example, imagine we get filled at the bid and pay $1.33 or $133.00 for the entire contract. (Due to the lack of open interest, this is not a contract we’d take. This is for illustration only)
Overall, this trade costs us: 133.00 – 97.00 = $36.00 (the difference between the premium received .97 x 100 and what we paid 1.33 x 100).
We want LUV to be at or very near the strike price of $39.00 by the Dec expiration. We do not want price to be below it and run the risk of assignment.
What Is Your MAX Risk?
The most you can lose when implementing a long calendar spread with puts is the amount you spent on the spread, including commission costs. In our example, the most we can lose is $36.00.
If the stock price strays too far from the strike price, then the puts will become worthless and you’ll lose whatever you paid for the spread.
The maximum loss would occur should the two options reach parity. This could happen if the underlying stock rose enough that both options became worthless, or if the stock declined enough that both options went deep in-the-money and traded at their intrinsic value. In either case, the loss would be the premium paid to establish the position.
When Do You Hit Breakeven?
The long calendar spread with puts has two possible points at which you will hit the breakeven mark; these happen if the stock either has a sharp move higher or lower before the short-term put expires. However, because this trade’s value is influenced by volatility, it is impossible to calculate exactly where these points are located.
Scenarios With LUV
Our stock is trading $39.59 and we bought a $39.00 strike price long calendar put spread that consists of selling a Dec 23 put for $0.97 and purchasing a Jan 13 put for $1.33. Our cost for this trade is .36 or $36.00 for the contract.
If LUV trades down to $36.00 by Dec expiration, the Dec puts would expire worthless. We are still sitting with the Jan puts we bought that are now worth $3.00 (decline in stock price) – .36 (premium we paid) or $2.64 profit. Some traders may hold onto the puts they bought (short position) as they expect the stock to continue to fall.
Imagine that LUV traded up to $44.00 by the early expiration date. Your Dec puts are now worthless and your Jan puts are far out of the money. You’d no doubt want to close your trade.
In a perfect world, LUV trades lower but does so after the near month contract has expired.
Exercise Risk Is Real
If the trader who bought the put you sold exercises their near-term option, the longer-term put would remain to provide a hedge against a potentially large transaction.
However, only around 7% of all option contracts are ever exercised.
In Conclusion
Long put calendar spreads are an option trading strategy that can offer traders limited risk with good potential for profit. By understanding the risks and scenarios associated with this trade, traders can potentially use it to their advantage when trying to capitalize on quick market movements.
It is important to remember that exercise risk is always present, no matter what strategy is used. Therefore, traders should always be aware of and prepared for this possibility when implementing long calendar spreads.
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