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Copyright Minyanville Media, Inc. The article you are trying to read is not available now. Thank you very much; you're only a step away from downloading your reports. You will receive a download link right in your email inbox for each of the free reports that you choose. The Power of Calendar Spreads. By Steve Smith Mar 20, Veteran options trader Steve Smith breaks down this strategy.

To help investors profitably navigate the options market, Minyanville has launched "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications.

In this series, veteran options trader and author of OptionSmith , Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers. In the past two weeks, we've gone over rookie mistakes to avoid as well as the basics of options pricing see: Now it's time to move on to trading methodologies, the first of which is calendar spreads. Calendar spreads, which are also known as time spreads, are one of the most useful options strategies out there because they allow us to make directionally-biased trades at a lower cost basis than with outright purchases of puts or calls.

Calendar spreads offer the hope-springs-eternal element that keeps us all coming back to trading options. Supposedly, time is on our side, and the never-ending cycle of options expirations means we can keep rolling our positions forward, always chasing that perfect confluence of time and price.

Calendar Spread Options Strategy - Fidelity

But that ain't the way I play it. I don't want to be beholden to time, or be led down some primrose path. If time doesn't make me money, I walk away and don't look back.

But enough with the fanciful and back to the prosaic. What exactly is a calendar spread? A calendar spread is constructed through two simultaneous trades: This combination creates a fairly neutral position that benefits from the accelerated time decay of the front-month option sold short. As we discussed last week , as an option gets closer to expiration, the rate at which time value decays accelerates.

In other words, the near-term option loses time value much more quickly than the longer-dated ones. The maximum profit would be achieved if the price of the underlying is at the strike price of the front month sold short at expiration, rendering it worthless.

But don't think calendar spreads are necessarily easy money. There is a significant challenge in getting the timing right. If the underlying stock price moves too quickly and deeply into the money, the value of the spread will decline as both options move toward intrinsic value. And few stocks trade in a straight line like Wal-Mart.

Option Spread Strategies | #1 in Options Results

In fact, most will try your patience of holding fast to an "unchanged" price over many months. In such cases, a "terminal value" call it takeout price or the lifting of unknown outcomes will cause the value of the shares to spike. But with the unknown event now clarified, the long-term option's implied volatility will plummet, and it will lose its time premium, even though there could be many weeks or months for the deal or decision to be handed down.

This is because much of the uncertainty regarding future price action would be removed.

And since calendar spreads benefit from the longer-term option retaining time value more effectively than the near-term dated one, they would suffer if the time premium was eliminated all at once. So, there are two important takeways here: A long calendar spread is a long volatility position. This means it benefits from an increase in implied volatility. A news event, such as the confirmation or failure of a merger, will diminish the range of possible outcomes, causing a decline in implied volatility, especially at the later-dated options.

The Diagonal Calendar Spread The diagonal calendar spread is one of the most useful calendar-spread variations. To construct a diagonal calendar spread -- and we'll just focus on a long spread here — we combine the following: This gives the position a stronger directional bias, or a higher delta than a straight calendar spread. If you're confused by the math: Nearly all that profit was the result of the shorter duration, further out-of-the-money call experiencing a greater rate of time decay.

In this example, with only a moderate increase in the stock price, and all else being equal, one can see how harnessing time decay can provide a powerful tailwind to profitability. On the other hand, by just buying the calls outright, one could have actually lost money -- even though the stock went up!

Calendar Spread Strategy | Options Trading at optionsXpress

Conclusion The possibilities for profits and adjustments on calendar spreads can be practically endless. My approach to calendar spreads in the OptionSmith portfolio is to keep them dynamic. I don't have static price targets. Rather, I respond to the market to best exploit the acceleration of time decay of the front-month option to provides an edge in the form of a lower effective cost basis.

One of my typical adjustments to calendar spreads is to roll the option sold short up to a higher strike to extend the position in terms of time and amount of premium taken in.

I do this frequently with names that offer weekly options such as the Spyder Trust SPY , Amazon AMZN , Google, or even iShares Barclay's Bond TLT. These never-ending mini-expiration cycles allow me to capture the steep part of the decay curve on a more frequent basis.

However, they also require more attention and willingness to take quick profits and losses when things don't play out as planned. One thing I should I add at this point is that options education is not linear, but rather circular. While you need to start at a certain point, such as understanding option pricing models, they really don't mean much until you start examining and applying certain strategies.

It may be a dizzying journey, but it's also a rewarding one. Click here for more details. Here is a complete schedule for "9 Weeks to Better Options Trading": Understanding Implied Volatility and Time Decay Week 3: The Power of Calendar Spreads Week 4: Butterfly Spreads Week 5: Condors; Iron and Others Week 6: Back Spreads Week 8: Managing Risk Week 9: Earnings Reports, Takeovers, and Extreme Market Moves For more from Steve Smith, take a FREE day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio.

Bing-Strategies-calendar-spread | Learn @ OptionsANIMAL

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