Pricing Calendar Spread Options - A Conservative Trading Plan
Pricing Calendar Spread Options
Implied Volatility (IV) for a stock is like a rubberband.It has the potential to stretch (go high) and compress (go very low) but ends up somewhere near the normal state most of the time during a year. Calendar Spreads initiated in a low IV period will benefit from any rise in IV (even if the price of the underlying does not change much). Calendar spreads initiated in a high IV environment run the risk of going down in value if IV starts going down. Therefore, the options Implied Volatility (IV) for the underlying should be below approximately 33 percentile (35 percentile is a value below which 35% of all the IV values are found for the entire year). Pricing Calendar Spread Options
Pick a stock from a stable industry for Calendar spreads. Avoid stocks in bio-technology sector or sectors that are extremely volatile in the current market.
Look at price charts for last week, 1 month and 3 months. Avoid stocks that have moved a lot during these periods. Safe bet would be to pick stocks that have not moved more than
5-7% in last 1 week
10-12% in last 1 month
15-17% in last 3 months
Focus on stocks that are channelling in a range.
IV for a stock tends to rise to its high percentile level during the earnings month. Once the earnings are out, the IV levels fall to their normal levels and stocks also tend to react violently to unexpected results. Avoid stocks that have earnings announcements in that month.
Typically, Calendar spreads would work well when the front month IV is greater than the back month (sell high IV and buy low IV). When there is a large IV skew between the front month and back month options (where front month IV is greater than back month IV by a big amount), it reflects some nervousness in the short term where the stock could move violently in the short term. Avoid stocks whose front month IV is greater than back month IV by more than 5 points. Pricing Calendar Spread Options
Most brokers charge commissions structure is based on number of contracts you trade. The more contracts you trade, the more you pay in commissions. Calendar spreads on low priced stocks ($40 or less) typically yield low absolute returns in per contract basis. Reduce the affect of commissions on your P&L by avoiding buying spreads in large contract numbers. Instead, focus on stocks that are greater than $40.
Initiate Calendar spreads where price of the underlying is not more than 3-4% away from the the strike price you choose.
Timing:
Best time to initiate a Calendar spread is between 30-40 days before expiration of the front month option.
Profit Goal:
20% (after commissions)
Maximum Loss:
25%. Once your position is down 25%, close the position.
Adjustments:
Once you initiate the Calendar spread, establish the breakeven (BE) points for your position (the upper and lower BE). If the stock moves to the BE point, make an adjustment by selling half of your original calendar spread and buying the same # of contract in another Calendar spread whose strike price is closer to the BE point. Pricing Calendar Spread Options
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