Options 101 - Modeling Calendar Spreads

As traders, it is prudent to model potential positions as part of ones due diligence prior to entering a particular trade.

With the aid of option simulation software, modeling can allow one to analyze all the relevant risks (delta, gamma, theta, vega) and understand the maximum loss and gain for any position over time.

The example used for this post is the 10-strike at-the-money August/September calendar spread for BAC.

Courtesy of Option Oracle, above is the theoretical payoff diagram for the position based on the price of BAC on August 20, the expiration day for front month of the spread. Furthermore, shown below, is the theoretical payoff diagram for the position based on varying volatility levels.

In this calendar spread example, the maximum risk, $19, is calculated as the net premium outlay for the position.

The maximum profit potential by August 20 is $19.70 per contract (103.66%). It is calculated based on ideal assumptions for the underlying and various Greeks. Specifically, it assumes volatility levels for each contract will remain constant at approximately 35% and that the position will remain delta neutral. Hence, it assumes there will be little price fluctuation. Consequently, because reality generally deviates from theory, it is highly recommended that sensitivity analysis be performed on all assumptions in any model.

Fortunately, option modeling programs like Option Oracle, allow one to do just that. As a cautionary concluding note, remember markets are dynamic and as a result, assumptions and decisions based on them must be constantly updated to maintain one's edge.

http://seaofopportunity.blogspot.com/*Special thanks to Option Radar, BMO Capital, MEB Options, Bloomberg, Reuters, Optionistics, LiveVolPro, CBOE, AMEX, Option Monster, T.O.P. group, and all of the options desks and traders we work with to provide the option flow!No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

Options 101: The calendar

The calendar or time spread is a position with options in two different expiration months, with both options being calls or puts. Both calls or puts will have the same strike price. Calendars involve buying an option in one expiration month and selling an option in another option with a different expiration. A long calendar is buying an option in the back month and selling an option in the front month. A short calendar is selling an option in the back month and buying an option in the front month.

Calendars maximize their value when the stock is at the strike price of the options, and the front month option is expiring. Calendars have their minimum value when the stock is very far away from the stock price of the options. Therefore, if you buy a calendar, you want the underlying stock price to be at the strike price at expiration. If you sell a calendar, you want the underlying stock price to be as far away as possible from the strike price at expiration.

The delta and gamma of a calendar depends on where the underlying stock price is relative to the strike price of the options.

Similar to calendars, a time spread with different exercise prices is a diagonal spread.