fbpx

Turning $80 Into $195 With a Calendar Spread Strategy

A calendar spread is a popular options trading strategy involving the simultaneous purchase and sale of options with the same strike price but different expiration dates. This strategy profits from time decay and changes in implied volatility, making it particularly effective in sideways or moderately trending markets.

In this article, we’ll dissect a practical example of a low-cost calendar spread using a case study involving UPS stock. By the end, you’ll understand how to set up, manage, and exit a calendar spread effectively while balancing risk and reward.

1. Setting Up the Trade

1.1 Trade Execution

  • Date and Time: The trade was executed on June 25th at 5:33 PM.
  • Details: A calendar spread was opened with a 115 strike price on UPS stock.
  • Cost: The initial investment was $0.20 per contract, multiplied by four contracts for a total of $80.

1.2 Rationale Behind the Trade

  • Market Conditions: The candlestick pattern on June 25th suggested a potential breakout.
  • Strike Price Selection: The 115 strike was chosen not as a target price but for its potential to appreciate rapidly due to time decay and volatility changes.
  • Objective: Create a low-cost trade with a high reward-to-risk ratio.

2. Initial Market Movements

2.1 Market Reaction

  • The anticipated breakout did not materialize on June 25th. Instead, the market experienced a downturn.
  • Impact: Despite this, the calendar spread began to show a profit as time passed and the stock started to climb back.

2.2 Bid/Ask Spread Analysis

  • Observation: Wide bid/ask spreads often create discrepancies in mid-price, which can mislead traders about unrealized profits.
  • Key Insight: Always cross-check mid-prices across platforms to avoid overestimating potential returns.

3. Managing the Trade

3.1 Scaling Out

Scaling out refers to partially closing positions to lock in profits and reduce risk.

  • First Adjustment: Sold one contract at $0.45, doubling the initial investment.
  • Second Adjustment: Sold another at $0.80 as the stock traded sideways.
  • Final Adjustment: Closed the last quarter of the position at $1.05, achieving a total profit of $195.

3.2 Risk Management

  • Profit Locking: By scaling out, the trader ensured no net loss, even if the remaining position turned unfavorable.
  • Exit Strategy: With just one day left until expiration and minimal profit potential, the position was closed entirely.

4. Key Lessons from the Case Study

4.1 Importance of Strike Price Selection

  • Choosing a strike price farther from the current market level lowers costs and maximizes potential returns, but it carries higher risk if the market doesn’t move as expected.

4.2 Managing Wide Bid/Ask Spreads

  • Wide spreads can inflate perceived profits. Always monitor realistic exit prices and avoid relying solely on the mid-price.

4.3 The Role of Scaling Out

  • Scaling out reduces risk but limits overall profit potential. It’s a trade-off between security and maximizing returns.

4.4 Time Decay as a Profit Driver

  • Calendar spreads thrive on time decay, particularly as expiration nears. However, the position must be closely monitored to avoid adverse outcomes from sudden market moves.

5. Practical Tips for Calendar Spreads

  1. Set Alerts: Use alerts to track significant price levels and breakout points.
  2. Monitor Volatility: Calendar spreads perform best in environments of increasing implied volatility.
  3. Patience and Adjustments: Allow time decay to work in your favor, but be prepared to adjust positions as market conditions change.
  4. Exit Before Expiration: Avoid holding a calendar spread until the final day, as the risk of rapid value erosion increases significantly.

Breakdown of the strategy in video

Frequently Asked Questions

Q1: What is a calendar spread?

A calendar spread is an options strategy where you buy and sell options with the same strike price but different expirations. It profits from time decay and changes in implied volatility.

Q2: How do you select a strike price for a calendar spread?

Select a strike price near the expected price movement. For low-cost trades, consider strikes farther from the current price to reduce initial investment.

Q3: What are the risks of wide bid/ask spreads?

Wide spreads can inflate perceived profits or losses. Cross-check prices across platforms and aim to execute trades near realistic exit points.

Q4: Why is scaling out beneficial?

Scaling out locks in partial profits, reduces risk, and allows you to remain in the trade for further potential gains.

Q5: How does time decay affect calendar spreads?

Time decay works in favor of calendar spreads, as the sold options lose value faster than the purchased ones. This dynamic contributes to profitability.

Q6: When should I exit a calendar spread?

Exit when the profit potential diminishes significantly, typically as expiration nears or when the stock moves adversely.

Conclusion

The UPS calendar spread example illustrates how to execute, manage, and profit from a low-cost options strategy. By balancing risk and reward through careful adjustments and scaling out, the trade achieved a 200% return. Employing this strategy with proper risk management can provide consistent gains in various market conditions.