A Directional Approach
Calendar spreads are often purchased when the outlook for the underlying is
neutral. Sell the short-term ATM option; buy the long-term ATM option;
collect theta. But with negative gamma, these trades are never really
neutral. The delta is constantly changing, becoming more positive or
negative. It’s like a rubber band: at times being stretched in either direction
but always demanding a pull back to the strike. When the strike price being
traded is not ATM, calendar spreads can be strategically traded as
directional plays.
Buying a calendar, whether using calls or puts, where the strike price is
above the current stock price is a bullish strategy. With calls, the positive
delta of the long-term out-of-the-money (OTM) call will be greater than the
negative delta of the short-term OTM call. For puts, the positive delta of the
short-term in-the-money (ITM) put will be greater than the negative delta of
the long-term ITM put.
Just the opposite applies if the strike price is below the current stock
price. The negative delta of the short-term ITM call is greater than the
positive delta of the long-term ITM call. The negative delta of the long-term
OTM put is greater than the positive delta of the short-term OTM put.
When the position starts out with either a positive or negative delta,
movement in the direction of the delta is necessary for the trade to be
profitable. Negative gamma is also an important strategic consideration.
Stock-price movement is needed, but not too much.
Buying calendar spreads is like playing outfield in a baseball game. To
catch a fly ball, an outfielder must focus on both distance and timing. He
must gauge how far the ball will be hit and how long it will take to get
there. With calendars, the distance is the strike price—that’s where the stock
needs to be—and the time is the expiration day of the short month’s option:
that’s when it needs to be at the target price.
For example, with Wal-Mart (WMT) at $48.50, a trader, Pete, is looking
for a rise to about $50 over the next five or six weeks. Pete buys the
August–September call calendar. In this example, August has 39 days until
expiration and September has 74 days.