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.
- 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.
- Aim to keep delta under 30 percent of theta +/-
- If trade is threatened either top or bottom we add a 2nd 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.
- 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.
- 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