Calendar Spreads – Notes from Mark Mosley Presentation

These notes are taken from the Raleigh “Durham Group Meeting Mark Mosley Calendar Spreads” found on youtube.

Here is an updated presentation to the original.

Tax Considerations

• IRS section 1256 trades are taxed at a rate of 40% short term Capital Gains (like your paycheck) and 60% long term Capital Gains (about half the rate of your paycheck)
• Qualifying Instruments SPX, RUT, NDX.

What is a Calendar Spread ?

• A bullish position- Sell a put (short dated) combined with…
• A bearish position- Buy a put ( long dated)
• Long and short legs are at same strike price.
• We would like the option we sold to decay in value, while…
• We would like the option we bought to retain as much value as possible.

Entry Rules for calendar spreads

• Enter any time, except do not enter during a volatility spike.
• Sell a At-The-Money Put or Call 60 to 80 DTE (Days to Expiration)
• Buy a long option the same strike 30 days beyond your short strike

Why not a shorter term?

• terrible Risk/Reward ratio 
• Narrow Range of safety

Pros of Longer-term

• Wide Range of safety
• If market crashes slower loss over time and time to adjust

What about the Greeks? 

Options Price = Delta + Theta + Vega 

• Delta = measurement of your directional risk
• Theta = Positive money flow
• Vega = Sensitivity to changing Volatility

In Think or Swim, you can find this on the analyze tab.

Management Rules

• Aim to keep delta under 30 percent of theta +/-
• If trade is threatened either top or bottom we add a 2^nd calendar ATM and manage the 2 as a pair, keeping Delta/Theta ratio under 30 %
• Manage according to Delta/Theta ratio and position under profit tent
• Try to ignore managing according to Profit/Loss dollar amount since it is normal to see wild swings in your daily P/L, due to constantly changing volatility levels.

But how are Calendar spreads affected by volatility? 

• Remember we want the leg we sold to decrease in value, and we want the long leg to retain value or increase.
• Volatility across time vs. volatility across strike price in the same expiration.

Term structure of Volatility

• In Options trading, Implied Volatility is how the market is pricing risk
• Normally short term contracts have a lower IV compared with longer term
• In a calendar spread, short and long leg IV can move independently of each other. This dynamic can give Calendar Spreads both positive and negative vega attributes.
• In practice, this is normally not a problem since IV is mean reverting.

So, How does volatility affect Calendars? 

• They can be both positive and negative vega, depending on how volatility is converging or diverging.
• Traditionaly considered Positive vega, meaning benefit from increasing volatility
• But can be Negative Vega, meaning benefit from falling volatility

Implied Volatility continued… 

• Remember, we sold a short dated leg…..if its volatility goes up, our position is hurt, if its volatility goes down we benefit.
• We bought a long dated option, if its IV goes up, we benefit, if its IV goes down, we are hurt.

How to handle changing volatility? 

• Manage according to Delta/ Theta ratio, your Profit/Loss figure can swing wildly and your trade still be OK.
• Because Volatility is mean reverting, giving your trade time will usually repair any adverse moves in your Profit/Loss. 
• Because we are Theta Positive, time heals all wounds.  (usually) 
• Most of all, don’t Worry! 

Most aggressive management rules

• Monitor delta/theta relationship keeping it under 20%
• Closing the trade is a day to day decision making process, weighing Delta/ Theta, considering position under the profit tent, and technical analysis forecasting market direction.
• Consider taking profits at 15%, for aggressive traders, let run to 30 %.
• Time- close by 30 DTE, or aggressive traders, no later than 21 DTE.

Exit rules 

• A conservative strategy would be to take profits at 10% of invested capital and close the trade, rolling out in time to the next expiration closest to 60/90 DTE
• A more aggressive strategy would be to hold closer to expiration and take profits at 20 to 30% of invested capital.
• Exit if time to expiration on short dated leg falls below 30 days.

Management tip

• If you ever unsure of the market, or the stability of a trade, you can always close the trade and roll out in time, aiming for at least 60/90 DTE entry.
• You can always cash out if worried about bad news.
• Keep profit tent over the ATM line on your graph, regardless of the greeks.
• You can always layer a second or third trade