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Calendar Spread Strategy: A Step-by-Step Approach

Introduction

Options trading offers a wide variety of strategies for investors looking to optimize returns. The calendar spread is one such tactic that has gotten traders' attention lately. Although its financial prospects seem fascinating, beginners may find it a bit intimidating. Let's deconstruct the intricacies of calendar spreads to explore what they're all about.

What are Calendar Spreads?

  • A calendar spread is a trading technique that takes both long and short positions with various delivery dates on the same underlying asset.
  • The rates of options contracts experience devaluation as their expiration dates draw closer, with the rate of decay-accelerating as expiration nears.
  • Calendar spreads profit by using different rates of time-based decay between short-term and long-term options.

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How Can a Trader Get Started?

With the same strike price and underlying asset, a trader simultaneously gets to buy a longer-term option and sell a shorter-term option to create a calendar spread. However, to build a calendar spread, these steps can be followed:

  • Picking an underlying asset

Investors must decide on a stock or another underlying asset from the list of options.

Example- 

An investor chooses XYZ Ltd. as his underlying asset because he has options available for trading; therefore, he employs options strategies.

  • Determining the strike price

Based on the market view, investors can choose the strike price for their calendar spread.

Example-

Based on his moderately bullish outlook, the investor selects a strike price of Rs. 1,250 for the calendar spread, slightly above the current market price.

  • Choosing the expiration dates 

This includes investing in a long-term call option and selling a short-term call option simultaneously with a similar strike price.

Example-

An investor purchases a long-term option and sells a short-term option on XYZ Ltd. at Rs. 1,250 each.

  • Predicting the maximum loss

Investors can subtract the net premium that was collected from the spread's initial cost.

Example- 

The net premium received for selling the shorter-term call option is Rs. 30, while the longer-term call option costs Rs. 50. Therefore, the initial cost for setting up the calendar spread is Rs. 20, i.e., Rs. 50 minus Rs. 30, which is also the maximum loss.

  • Monitoring and modification

Investors need to keep an eye on their positions and modify investments if market circumstances change.

Example-

Over the next month, if XYZ Ltd. remains stable or moderately bullish, the short-term call options investor may lose value due to time decay. They can choose to let it expire or buy it back at a lower price to avoid losses.

Conclusion

  • Calendar spreads are useful for options traders looking to profit from time decay while controlling risk.
  • They can be used well with a good risk management plan and a clear market view.

 

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