Long Calendar Spread w/Puts

The Strategy

When running a calendar spread with puts, you’re selling and buying a put with the same strike price, but the put you buy will have a later expiration date than the put you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) put as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term put for next to nothing. At the same time, you will sell the back-month put to close your position. Ideally, the back-month put will still have significant time value.

If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money puts. If you’re mildly bearish, use slightly out-of-the-money puts. This can give you a lower up-front cost.

Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value. You can only capture time value. However, as the puts get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.

For this Playbook, I’m using the example of a one-month calendar spread. But please note it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.

The Setup

• Sell a put, strike price A (near-term expiration - “front-month”)
• Buy a put, strike price A (with expiration one month later - “back-month”)
• Generally, the stock will be at or around strike A

Who Should Run It

Seasoned Veterans and higher

NOTE: The level of knowledge required for this trade is considerable, because you’re dealing with options that expire on different dates.

Break-even at Expiration

It is possible to approximate break-even points, but there are too many variables to give an exact formula.

Because there are two expiration dates for the options in a diagonal spread, a pricing model must be used to “guesstimate” what the value of the back-month call will be when the front-month call expires. Most brokers that specialize in option trading have a Profit + Loss Calculator that may help you in this regard. But keep in mind, most Profit + Loss Calculators assume that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.

The Sweet Spot

You want the stock price to be at strike A when the front-month option expires.

Maximum Potential Profit

Potential profit is limited to the premium received for the back-month put minus the cost to buy back the front-month put, minus the net debit paid to establish the position.

Maximum Potential Loss

Limited to the net debit paid to establish the trade.

NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on how the back-month put performs.

Margin Requirement

After the trade is paid for, no additional margin is required if the position is closed at expiration of the front-month option.

As Time Goes By

For this strategy, time decay is your friend. Because time decay accelerates close to expiration, the front-month put will lose value faster than the back-month put.

Implied Volatility

After the strategy is established, although you don’t want the stock to move much, you’re better off if implied volatility increases close to front-month expiration. That will cause the back-month put price to increase, while having little effect on the price of the front-month option. (Near expiration, there is hardly any time value for implied volatility to mess with.)