Calendar Put Spread

When to Apply a Calendar Put Spread?

The best time to apply a calendar put spread is when you believe that an underlying security won't move in price for a relatively short period of time i.e. you have a neutral outlook. Unlike a number of neutral strategies, you aren't exposed to unlimited losses should the price of the security break out in either direction.

The most you can lose is the cost that you incur when applying the spread. This makes this an attractive strategy to use if you do have some concerns that your neutral forecast could be wrong and the security may actually move in price significantly.

Establishing a Calendar Put Spread

Establishing a calendar put spread is a two-step process. First you use the sell to open order to write puts based on the particular security that you believe won't move in price. These should have an expiration date in the near term, preferably in about a month. Second, you use the buy to open order to buy an equal number of puts that are based on the same security and have the same strike, but one that expires later than the ones written.

These two transactions should be carried out simultaneously unless you are confident enough to use legging techniques. The contracts bought will be more expensive than the ones written, because they will have more time value, but you will incur a cost for establishing the spread.

This is a horizontal spread that uses options with the same strike, but you can choose what this strike is. Most traders will tend to use a strike that is the same as the current trading price of the underlying security (i.e. they will be buying and writing at the money contracts), but you can use a slightly lower strike to reduce the upfront cost.

Below we have shown an example of a calendar put spread, and used at the money strikes. We should point that the options prices used are hypothetical and not real market values.

• Company X stock is trading at $50, and your belief is that it will remain at that price in the short term.
• At the money puts with a month until expiration are trading at $2. You write 1 contract containing 100 of these options and receive a credit of $200. This is Leg A.
• At the money puts with three months until expiration are trading at $4. You buy 1 contract containing 100 of these options and spend $400. This is Leg B.
• The calendar put spread is created for a net cost of $200.

Profits & Losses

Any profit is essentially down to the effects of time decay, and the fact that the rate of time decay is fastest when options are approaching their expiration date. The expectation when applying this spread is that the value of the options written will decay at a faster rate than the value of the ones bought.

Assuming the price of the underlying security doesn't move, the options written will expire worthless and the ones owned will still be worth enough to cover the initial investment and return a profit. In those circumstances, the profit can be calculated as follows.

• “Total Value of Options Bought in Leg B – Initial Net Investment”

Although you should make a profit when the price of the underlying security hasn't moved by the time the options in Leg A expire, it isn't really possible to accurately predict exactly how much you will make. You can apply calculations to determine roughly what the effects of time decay will be (using the Greeks and a pricing model such as the Black Scholes model), but you cannot be completely sure of what the price of the options bought will be, even if you assume that the price of the underlying security doesn't move at all.

You do, at least, know what the maximum possible loss will be, and that is the cost of establishing the spread at the outset. If the underlying security falls in price, then the put options written in Leg A will increase in value and give you a liability. However, any such liability will be offset by the options bought in Leg B also increasing in value.

If the options written were assigned and you were forced to buy the underlying security at the strike, you could exercise the options you own and also sell the security at the strike. Alternatively, you could simply sell the options and cover the liability that way.

If the underlying security went up in price, then the options written in Leg A would expire worthless: meaning no liabilities. Even if the options bought in Leg B were also worthless, you still would only lose your initial investment. In practice, the options bought in Leg B would at least have some value still, so you could sell them and recover some money that way.

Alternatives

As we have already mentioned, the calendar put spread is very similar to the calendar call spread, so you can choose to use calls if you prefer. You can also slightly adjust the spread and buy puts with a higher strike than the ones you write (thus creating a diagonal spread). This will cost you slightly more at the outset, but it means that you will make more profits if the underlying security should fall in price a little.

Summary

If you are trying to profit from a security not moving in price but want to limit your potential losses if the security should move in price, then the calendar put spread is a good strategy to use. This strategy is all about trying to capture profits through putting the effects of time decay in your favor when the price of a security is stable, without being too badly affected if the price moves unexpectedly.

The main disadvantage here is the fact that the effects of time decay can't necessarily be forecasted with 100% accuracy, which means you can't predict exactly how much money you might make.