Calendar Spread Basic Setup Question

[LaxFan]

I understand the basics of calendar spreads--i.e short the near-term option/buy the longer dated option. However, I have two questions regarding constructing a trade?

Say XYZ is trading at $50 and you have a neutral outlook.

1. How do you decide whether to use calls or puts?

2. How decide on the strike and dates to use for the calendar (i.e. 30 and 60 days, 7 and 14 days, etc.).

Essentially, I understand the concept, just not sure how I would actually choose the elements to set one up.

 

[stepandfetchit]

I understand the basics of calendar spreads--i.e short the near-term option/buy the longer dated option. However, I have two questions regarding constructing a trade?

Say XYZ is trading at $50 and you have a neutral outlook.

1. How do you decide whether to use calls or puts?

2. How decide on the strike and dates to use for the calendar (i.e. 30 and 60 days, 7 and 14 days, etc.).

Essentially, I understand the concept, just not sure how I would actually choose the elements to set one up.

Take with grain of salt, as I am not proficient with time spreads yet. You chose the strike associated with where you think the underlying will move to by the time you plan to close the trade. The choice of PUTs vs CALLs "should" not matter unless you develop a preference. -- Most of us develop a preference. -- The date is related to how much time your "insight" requires to materialize. -- If you have no idea of the date, you may want to reconsider your plan of using calendars, or "play" with money you expect to lose!

 

[destriero]

I understand the basics of calendar spreads--i.e short the near-term option/buy the longer dated option. However, I have two questions regarding constructing a trade?

Say XYZ is trading at $50 and you have a neutral outlook.

1. How do you decide whether to use calls or puts?

2. How decide on the strike and dates to use for the calendar (i.e. 30 and 60 days, 7 and 14 days, etc.).

Essentially, I understand the concept, just not sure how I would actually choose the elements to set one up.

There is no difference between calls and puts at a strike. If you trade both you're simply doubling size. As you add days you add vega. You're short gamma so you want a strike touch.

 

[taowave]

Without going into skew and greeks,you could take a simple approach and look at your reward to risk metrics and choose the one you find most favorable per your outlook.

Look at the calendars max value if the stock goes out at your short strike. Then compare it to the price paid for the calendar..

If you arent a derivatives guy(non hedger/non greek),you my choose calendars with a debit no more than X.

Im assuming you are choosing calendars as a directional play?

You may want to compare them to the corresponding fly

 

[MrMuppet]

Careful here, the setup isn't as simple as you make it. If term structure is steep you'll lose to term structure vol roll down, since selling the near term and buying the far term is a position that is net long vega.

More often than not you'll be better off selling the calendar, meaning you buy the near term and sell the far term when realized is low and the far term is overpriced.

 

[Robert Morse]

#1-Which everyone has tighter spreads and looks more liquid as it should not matter unless one becomes well ITM. Then you need to calculate early exercise risk on the short side. #2- You need to have an opinion as to how long movement will be "neutral." You also need an exit plan for when you are wrong and right. Max profit should never be an expectation and max loss should never be allowed to occur.

I understand the basics of calendar spreads--i.e short the near-term option/buy the longer dated option. However, I have two questions regarding constructing a trade?

Say XYZ is trading at $50 and you have a neutral outlook.

1. How do you decide whether to use calls or puts?

2. How decide on the strike and dates to use for the calendar (i.e. 30 and 60 days, 7 and 14 days, etc.).

Essentially, I understand the concept, just not sure how I would actually choose the elements to set one up.

 

[newwurldmn]

I understand the basics of calendar spreads--i.e short the near-term option/buy the longer dated option. However, I have two questions regarding constructing a trade?

Say XYZ is trading at $50 and you have a neutral outlook.

1. How do you decide whether to use calls or puts?

2. How decide on the strike and dates to use for the calendar (i.e. 30 and 60 days, 7 and 14 days, etc.).

Essentially, I understand the concept, just not sure how I would actually choose the elements to set one up.

neutral view = use ATM or ATM forward.

dates based on your view of the term structure of vol. The calendar is a view on forward vol. You take a view that the vol up to the first maturity will be different that then market's view from the first to the second maturity. In the long calendar: you are betting the front vol is way overpriced but the market will believe that the back vol should be relatively higher. So you pick your tenors based on where you see that pricing.

 

[taowave]

LOL,I knew the big guns would come out and take it up a couple of levels....

Mup is right,and if I read him correctly,hes saying for an upside Calendar, as you are long Vega, if the stock rallies to the short strike,you are most likely to find that your long option will be trading at a lower vol than anticipated..

NWD is talking time skew,but you still have to pay close attention to the overall level of vol especially pre earnings(short leg),as Implied typically gets blasted after earnings are announced..

Robert brings up a great point,and one I still go back and forth on..No doubt you should have a plan as to profit target and stop,but that could mean many things. What i would suggest is you take a look at Orats and backtest various Calendars and simulate them with stops and profit targets vs punting,i.e letting the chips fall where they may.I am not so sure setting stops/profit targets are the magic bullet,but i could be 100 percent wrong.I will run backtests over the weekend..

FWIW,if I do a calendar and lets say sell 30 vol and buy 20 vol,I check to see if I still have edge on a flat 15 vol..

Are you looking at calendars as a directional play or vol/skew play?

#1-Which everyone has tighter spreads and looks more liquid as it should not matter unless one becomes well ITM. Then you need to calculate early exercise risk on the short side. #2- You need to have an opinion as to how long movement will be "neutral." You also need an exit plan for when you are wrong and right. Max profit should never be an expectation and max loss should never be allowed to occur.

 

[Robert Morse]

In many cases when the front month is materially higher than the next month, there is likely an event before the first expiration. If you want to estimate your breakeven price movement, you need to estimate both IVOLS after the event and look to see where you breakeven at those expected IVOLs.

FWIW,if I do a calendar and lets say sell 30 vol and buy 20 vol,I check to see if I still have edge on a flat 15 vol..

 

[destriero]

You guys need to get out of the weeds here,