When you have an idea of a specific market price, a long put calendar spread can be an effective strategy. By buying longer-term puts and selling shorter-term ones at the same strike price, you can profit if the stock hovers around that strike. This guide explains how this strategy works to increase your profit possibilities with this approach.
Key takeaways
- A long put calendar spread is a strategy requiring buying longer-term puts and selling shorter-term ones at the same strike price.
- You will want the stock to hover around the strike to maximize your profit potential.
- With Option Samurai, you can pick a strategy with a high IV difference and an expectation of no particular trend in the near future to increase your profit chances.
What Is a Long Put Calendar Spread?
Think of a long put calendar spread as a simple combination of two options:
- Buy one “longer-term” put.
- Sell one “shorter-term” put with the same strike price.
Consider Home Depot (HD), currently trading at $325.10. Suppose you have reasons to believe that the stock will hover around $325 for several weeks. These reasons may vary, for example:
- You believe the company is fairly valued at $325 by looking at its financials.
- You spot a strong support/resistance level around this price.
In this case, you could:
- Sell a $325 put expiring in 10 days.
- Buy a $325 put expiring in 6 weeks.
You want the stock to hover around $325 to maximize your profit, estimated at roughly $350. You will lose if HD moves below $317.63 (maximum loss estimated at roughly $580) or above $334.71 (maximum loss estimated at $380).
The image above shows you the P&L profile from the strategy. Note that, due to the two different expiration dates, we’re only showing you the P&L scenario at the closest expiration between the two trade legs.
A Real-Life Example of a Long Put Calendar Spread
We have just seen an example on HD, but let’s dig a little bit deeper with another real-life market case to better explain the long put calendar spread. Take, for instance, Moderna (MRNA). This is a pharmaceutical company which you know tends to have huge price swings following decisions from the FDA in the US or competitors’ announcements.
Now, let’s assume that you have done your research and you believe that the stock’s fair price is around $160 (at the time of writing, MRNA was trading at $166.61). The fair price value is probably not sufficient for this type of trade, so let’s say that you have also checked the FDA official calendar and saw no announcements regarding any ongoing clinical trials from MRNA. You did this research about MRNA competitors (such as Pfizer), too, and let us say you came to the same conclusion.
You could even take a look at technical analysis (which is often meaningless in the long term but can be a good tool in the short run), and saw that many indicators are pointing to a stagnant few weeks in MRNA.
Take a look at MRNA’s historical price chart to get a better idea of your likelihood of success:
MRNA has just jumped to $160 on positive news a few days ago, and it is slowly moving even higher. However, you don’t think this strong upward movement will last and believe that traders won’t push MRNA’s price much higher, but they also won’t let it fall significantly.
If everything holds, you could set up a long put calendar spread as follows:
- Sell a $160 put expiring in 3 weeks.
- Buy a $160 put expiring in 7 weeks, as our options screener could show you.
Consider the P&L profile of your strategy (see the image below). Once again, remember: you’re only looking at the P&L profile referred to the closest expiration date in your trade:
Your profits will peak if MRNA hovers around $160, and you’ll be able to earn over $500. You could lose money when MRNA’s price moves either below $147.33 or above $176.68. In both cases, the loss would be lower than $400.
A Summary of Our Example
In this example, you’ve combined fundamental analysis (fair price, competitor analysis), technical analysis (price charts, indicators), and strategic planning (selecting expiration dates) to create a long put calendar spread. This approach allows you to potentially capitalize on a period of price stagnation within a specific range.
This strategy highlights the importance of thorough research and careful planning. By understanding the factors that affect the underlying stock and leveraging the characteristics of options, you can create a position that maximizes profit potential while managing risk.
Charts, options screeners, and other tools can further enhance your ability to visualize and execute these strategies effectively. Remember, the key to a successful long put calendar spread lies in your ability to predict and react to market conditions accurately.
This real-life example demonstrates how a long put calendar spread can be a viable option in a calm market environment, allowing traders to take advantage of periods where significant price movements are not likely to occur.
Look Out for the IV Difference Between the Two Options Legs
The IV ratio is really key for setting up a long put calendar spread. Basically, you just divide the front-month-IV by the back-month-IV. It’s especially handy when you’re assessing a bunch of potential trades right before the market closes.
Here’s how it breaks down:
- IV Ratio > 1: The option you’re selling (front-month) has higher implied volatility, making it pricier due to expected significant movement.
- IV Ratio < 1: The option you’re buying (back-month) has a higher implied volatility. Traders usually favor spreads where the sold option has a higher IV than the long-term option for the long put calendar spread.
Note that, in general, you will observe longer-term options to have a higher IV. This is perfectly normal due to the way market expectations form, and it means that you will often observe the IV ratio to be lower than 1. But in those occasions where we are above 1, you will find yourself dealing with trades having a high risk and high reward profile.
Also, if you are not interested in banking on IV changes, you should probably consider other types of trades for your portfolio. Iron condors and debit/credit spreads are simpler strategies that do not rely on a change in IV to give you a profit.
What does this mean for you? Focusing on trades where the front-month option has higher implied volatility (IV) than the back-month option positions you to benefit from a gradual reduction in IV differences.
Typically, a rise in IV benefits the longer-term option in your spread, creating opportunities for potential gains. This strategy makes it easier to identify prime opportunities without being inundated with data, offering a clear path for making informed decisions at critical moments.
Let’s go back to the MRNA example for a second. We told you about all the different parameters you could select for this trade, but we did not mention IV as we wanted to dedicate a short section to it. The trade idea had an IV ratio of roughly 1.30 (see image below), indicating a favorable condition for a long put calendar spread:
Overview of the Long Put Calendar Spread Strategy Profile
There are several aspects you have probably already inferred from our previous example, but let us be more explicit.
The long calendar spread with puts is a neutral strategy that profits from low volatility in the underlying stock, and it involves buying one put option with a longer expiration date, and selling one put option with a shorter expiration date at the same strike price. This type of strategy can be useful for those who prefer to limit their risk but still want to take advantage of potential gains in the market. It is also known as a “long time spread” or a “long horizontal spread.”
The main goal of the long put calendar spread is to make money from changes in volatility and time erosion. “Vega” measures how much changing volatility affects the net price of a position, and “Theta” measures how much time erosion affects the net price of a position. In a long calendar spread with puts, the net vega is slightly positive because the vega of the long put is slightly greater than the vega of the short put. As expiration approaches, the net vega of the spread approaches the vega of the long put, because the vega of the short put approaches zero. This means that as time passes and volatility remains constant, the value of the spread increases.
The impact of time erosion becomes more positive as expiration approaches because the value of the short-term short put decays at an increasing rate. However, if the stock price rises above or falls below the strike price of the calendar spread, the impact of time erosion becomes negative. In these cases, the time value of the shorter-term short put approaches zero, but the time value of the longer-term long put remains positive and decreases with passing time.
One can also compare long calendar spreads with puts to other neutral strategies such as short straddles and short strangles. These strategies also profit from “low volatility” in the underlying stock, but they require a larger initial investment (or margin requirement), have unlimited risk, and have a larger, albeit limited, profit potential. In contrast, long calendar spreads require less capital, have limited risk, and have a smaller limited profit potential. This makes them a more appealing option for traders who do not want to take on the unlimited risk of short straddles or strangles.
It is important to note that while the risk is limited with long calendar spreads, it is still 100% of the capital committed. Therefore, like any strategy, it is crucial to carefully consider the amount of capital that will be placed at risk and potentially lost with the long put calendar spread if the market forecast is not realized.
Early Assignment is a Real Risk to Consider
Early assignment is a significant risk in a long put calendar spread, particularly with the short put leg. In the U.S., stock options can be exercised on any business day, and you may face early assignment without warning, often around ex-dividend dates.
Strategies to manage early assignment risk
- Close the entire spread: Sell the long put and buy back the short put.
- Buy back the short put: Keep the long put open while eliminating the immediate risk.
If early assignment occurs, you’ll end up with a long stock position. You can:
- Sell the stock: Preferable if the long put still has a time value.
- Exercise the long put: This forfeits the remaining time value but closes the position.
Be mindful that closing a stock position a day after purchase incurs extra fees and potential interest charges. Also, early assignment might trigger a margin call if your account lacks sufficient equity.
Focus on Effective Market Forecast
A long put calendar spread realizes its maximum profit if the stock price equals the strike price on the expiration date of the short put. Your market forecast is crucial and can be “neutral,” “modestly bullish,” or “modestly bearish,” based on the stock’s relation to the strike price at the time of establishment.
- Neutral Forecast: If the stock price is at or near the strike price when you start, you expect no significant price changes.
- Modestly Bearish Forecast: If the stock price is above the strike price, you anticipate a drop to the strike price by expiration.
- Modestly Bullish Forecast: If the stock price is below the strike price, you expect it to rise to the strike price by expiration.
The long put calendar spread is also known as a “long time spread” or “long horizontal spread.” “Long” signifies the strategy involves a net debit or cost. “Time” indicates different expiration dates, while “horizontal” refers to how options were listed in newspapers, with strike prices vertically and expirations horizontally, hence the name.
Making an accurate forecast ensures your long put calendar spread aligns with market conditions, maximizing profit potential while effectively managing risks.
