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Jim SH here for Calculated Risk. And don't forget, before we get started, the best ways you can help us are by liking the video or subscribing to the channel.
Learn when and how to trade calendar spreads to buy volatility, focusing on strike selection, stock price, and managing debit strategies.
Key Takeaways
- Calendar spreads are debit strategies designed to profit from volatility expansion and time decay.
- Prefer higher-priced stocks and put calendars for better management and volatility benefits.
- Strike selection should be near the current stock price for a neutral stance but can be adjusted for directional bias.
- Manage risk aggressively at 10-25% of the debit paid to optimize returns and limit losses.
- High volatility environments may reduce calendar spread effectiveness; best used when volatility is low or contracting.
Summary
- Tasty Live generally prefers selling premium but occasionally buys volatility using debit strategies like calendar spreads.
- A calendar spread involves selling a front-month option and buying a back-month option at the same strike price.
- The strategy benefits from time decay on the short front-month option and volatility expansion on the long back-month option.
- Calendar spreads are typically used when volatility is low and are more effective on higher-priced stocks for better economic significance.
- Strike selection is usually neutral, near the current stock price, with a preference for put calendars to benefit from volatility expansion during market downturns.
- Management of calendar spreads is aggressive, typically at 10-25% of the debit paid.
- The front-month extrinsic value should exceed the debit paid to increase the chance of profitability from time decay.
- Example setup shown using Meta stock with a $14 debit calendar spread, emphasizing the importance of account size and risk management.
- Volatility and market price typically move inversely, so calendar spreads can benefit from rising volatility when prices fall.
- Current high volatility environments may not be ideal for selling premium calendar spreads, but they become attractive when volatility contracts.
Chapters
- 00:00Introduction and Video Support Request
- 00:21Buying Volatility with Calendar Spreads
- 00:51Calendar Spread Structure Explained
- 01:23Volatility and Vega in Calendar Spreads
- 01:56Choosing Stocks for Calendar Spreads
- 02:39Setting Up a Calendar Spread in Meta
- 03:18Strike Selection and Neutral Strategy
- 03:50Preference for Put Calendars and Volatility Relationship
- 04:56Example Setup and Debit Management
- 05:54Extrinsic Value and Profit Potential
Full Transcript — Download SRT & Markdown
Speaker A
Either one of those, guys, really helps us out a lot. So, generally speaking here at Tasty, we like to sell premium, right? We want to play into the high probabilities. We want to play into the positive theta. We want to be on the
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short side of the option contract, generally speaking. But every once in a while, we also like to flip the script.
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Like every once in a while, we like to buy volatility. Every once in a while, we like to use debit strategies and kind of play for volatility rising. And one of the classic strategies to set up for that type of play is a calendar spread.
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So, what I want to do, uh, what I want to do today is hop into the platform and let's set up a calendar spread. But before we set this guy up, let's just talk in general terms: what does a
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calendar spread look like? Well, it is going to be a multiple expiration cycle strategy where you're selling the front month and you're buying the back month.
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You're choosing the same strike in both months. So, it's very much an overlapping feature of the strategy between the short option in the front month and the long option in the back month. And the reason why you set the
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strategy up this way is because you want to take advantage of two elements. You want to take advantage of time decay even though it's a debit strategy. And you also want to take advantage of any potential volatility expansion. So, the
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time decay comes from the simple fact that that short option that you're selling in the front month, it's going to burn faster than the back month. It's going to decay more quickly than that long option that is sitting in that back
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month. And for the volatility aspect, the back month option is going to have a higher Vega than the front month option.
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And so by having that higher Vega in the back month, if there is any volatility expansion in that underlying stock, you are likely going to see a pop in your P&L from that volatility expansion. This is why we typically like to do calendar
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spreads when volatility is on the lower end of the range. So, all right, let's hop into Tasty Trade and let's set one of these up. All right, so here I am inside of my Tasty Trade platform and I've got Meta pulled up and this is a
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$600 stock. Okay, so the first thing you want to understand is we really like to use calendar spreads on higher price stocks. So, not necessarily $600, but the price of the stock doesn't necessarily kind of preclude or prohibit you from doing a
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calendar spread in that stock because the higher price of the stock really plays well with the more aggressive management style that we typically deploy with calendar spreads. We're typically managing these spreads at 10 to 20 to 25% of our debit paid. And so
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if you choose a really low price stock like a $50 stock or a $75 stock, it's going to be a super cheap calendar spread, which is nice because that is indeed your maximum loss, but it's just not going to give you a whole lot of
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economic significance when it comes to the profit potential on that strategy. So, okay, so I'm in Meta. The way that we would generally set up a calendar spread is going to be, again, I'm selling the front month and I'm buying the back
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month. Don't worry about the earnings right now for the purposes of this illustration. We'll come back to that at a later date. Usually, we like to be at about a 1:2 ratio between the front month and the back month. So, you can
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see we're at about that ratio right here with this Meta calendar spread. So, when I go to set this guy up, I'm going to open up my July cycle first. Now, in terms of the strike selection, remember, we're going to be selling and buying the
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same strike. So, the 580 in bull cycles or the 560 in bull cycles or what have you. Usually calendar spreads, the spirit of the calendar spread is more of a neutral strategy. So you're usually typically choosing a calendar spread
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with some strike around where the stock is currently. Now you want the stock to pin the strike. So whatever you choose, that's where you want the stock to go.
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So if you want to be more directional, then you can certainly choose strikes on the low end. You can certainly choose strikes on the high end if you want to be more bearish or more bullish. But usually the spirit of a calendar spread
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is more of a neutral strategy. On that note, we typically prefer put calendars relative to call calendars. It's not a huge difference, but remember this is a volatility expansion play. This is a long volatility play. So, if volatility
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rises, that's going to help our calendar spread. Well, we know, or maybe you don't know, and maybe this is the first time you're hearing it, but market prices and market volatility typically move inversely. So, when market prices are down, volatility is typically up.
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You can even see it on a day like today where the market is down huge and volatility is up pretty significantly.
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And so we typically observe this relationship across the board with a lot of individual stocks as well. So if I'm playing volatility to expand, I'm playing volatility to the upside, then I want to position myself to potentially extract as much benefit from that
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volatility expansion as I possibly can. To choosing the put option slightly below where the stock currently sits.
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Even if it is mostly neutral, choosing a 580 or 575, that's going to allow me to situate my strike such that if there is volatility expansion and the stock price moving lower, that's going to really help me. So right here, let's say I sell
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a 580 strike, which is just slightly below where Meta is right now in July, and then I close up July. I go to August and I buy the same strike, the 580 strike. And so notice how this is a
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debit of $14 on this strategy. So this is a fairly significantly priced calendar spread. You would probably want to have, I would say, maybe $30,000 in your account or so, or maybe even more than that, or maybe even a little bit
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less. But this is not going to be a strategy for a tasty bite-sized account.
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But if I'm managing this at 10% of debit paid, that's 140 bucks. 20% of debit paid, that's 280 bucks. It's pretty significant when it comes to the management. When I'm using my or when I'm selecting my strikes, I want to make
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sure that the extrinsic value in the front month is over and greater than the debit that I pay in the strategy. This gives me the best possible chance to make money from time decay because I know if nothing happens and the stock
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just sits here, which we know that it won't, but if it just meanders around and ends up back here when all is said and done, then all that extrinsic value that came off of that front month is going to cover the debit that I pay in
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the strategy and it's going to effectively make it a little bit easier for me to make money. So this $14 and some odd cents. If we go back to July where my front month is, you can see I'm
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collecting over $22 in extrinsic value. I know that that's all extrinsic value because this option is out of the money.
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And so the way that this calendar spread is setting up in Meta looks pretty good.
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This would be a great candidate for a calendar spread. And so hopefully this kind of makes sense from the higher priced stock preference to the put preference. It's mostly a neutral strategy managing aggressively at 10 to 20% or even 25% of debit paid and then
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making sure that front month extrinsic covers the debit. So, okay. So, that is a calendar spread. Hopefully that makes sense and we kind of covered the major points of setting up a calendar spread.
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Now, in today's market with the VIX skyrocketing and volatility rising, this may not be the best market to sell a call or put on a calendar spread in. But when volatility eventually collapses, when volatility eventually contracts, as we
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know that it will, if history is any guide now, hopefully you are read.
Topics:calendar spreadoptions tradingbuying volatilitydebit strategytime decayvolatility expansionput calendarstrike selectionhigh priced stockstastytrade
