Understanding Calendar Spread in Trading to Maximise Profit

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  • 04 Oct 2023

When there is no major movement in the market, it entails selling an option with a shorter expiration date while simultaneously buying a call or put option with a lengthy expiration date to manage risk. It is a method by which investors might make money over time or in an environment of elevated implied volatility. Having a trustworthy partner is crucial when using advanced options trading tactics like calendar spreads. Kotak Securities gives traders a platform on which they can efficiently use these tactics.

A calendar spread is an option or an future trade strategy which works on simultaneously entering in a long & a short position for the same underlying asset but on a different delivery date of the contract. By purchasing one contract and selling the other, you could, for instance, build a calendar spread between the Nifty June and Nifty July. In this approach, the calendar spread's payoffs depend on the spread's potential to broaden or contract. For instance, according to the definition of the Calendar spread, you go long on the spread when you anticipate it to widen, and you go short on the spread when you anticipate it to decrease.

When a call or put option with the same strike rate and separate expiration dates is purchased and sold, the transaction is frequently referred to as a time spread. A long calendar spread is executed when a trader sells a short-dated option and purchases a long-dated option. It makes the transaction more affordable than paying cash for an out-of-date choice.

Long calendar spreads come in call-and-pull varieties. Compared to call calendar spread, put calendar spread has some advantages. Which one should you exercise? Executing put options when the market outlook is negative and call options when it is bullish is the usual rule of thumb.

Planning a calendar spread begins with studying market mood and looking at several months' worth of market forecasts. Let's use an example to comprehend it better. When the overall market trends are anticipated to remain neutral for some time, but the trader's outlook is pessimistic, he or she may decide to construct a put calendar spread.

  • Any financial instrument with a liquidity quotient, such as stocks or exchange-traded funds (ETFs), for which discrepancies between the bid and ask prices are small, can be traded using the calendar spread options method.

  • Think about trading covered calls. When an investor sells call options, they must match the same amount of the underlying securities if the buyer decides to exercise the call option. This transaction is known as a covered call in the financial market.

  • When the market is balanced for a brief period, traders might engage in a spread. With this legging technique, traders can avoid price drops in stocks that are typically headed up. Legging in is the process of taking several separate positions to create a larger stake in order to close an options agreement.

  • The factors connected with early-stage limited uptrends and various expiration dates must be taken into account by traders in an effort to reduce losses.

  • Choosing the right entry time is a vital decision that affects the deal's profit. An experienced trader will keep an eye on the market over time in order to match trading choices with underlying trends.

  • Before trading, always take a look at the profit-loss (P-L) graph.

  • Set a maximum profit goal and prepare to leave when you reach it.

  • Major earnings announcements should not be relied upon unless you intend to profit from inflated implied volatility. However, these are extremely risky purchases that could result in a big loss if the market experiences a significant post-earnings move.

The futures of the same stock are bought and sold in a calendar spread, but the contracts have various expirations, as in the example of Reliance Industries above. What is anticipated to be made in this situation is the difference between the prices of the two contracts. In the example above, the calendar changed from a positive to a negative spread, so you naturally received an additional benefit and made a larger profit. Calendar spreads have a very low trading risk, so the earnings you can expect to make are likewise modest. This is more suited to risk-averse institutions that focus on volume in order to generate rupee gains for them.

We have now reached the final feature of the calendar spread. How do you determine whether a certain contract is priced fairly or excessively? You must use the cost of carrying approach or the basic approach for it. The stock price anticipated is the futures price. In other words, the spot price is nothing more than the projected futures price's current value. You may determine which contract is underpriced and which is overpriced using the cost of carrying method. Then, in accordance, you buy the contract that is underpriced and sell the one that is overvalued, resulting in a calendar spread.

Just a warning, please. A calendar spread only continues to be low risk provided you keep the position as a spread. For instance, it would be incorrect to simply record profits on one leg while holding onto a naked position in the other leg if you were generating money on that leg. When the calendar spread's logic is violated, it turns into a speculative trading position with significant risk implications. As a result, the Calendar spread can only be opened and closed using a combination approach.

Conclusion

Calendar spreads are useful trading tools for options, particularly in neutral market conditions. They entail concurrently taking long and short positions for the same underlying asset with various delivery dates. Using this approach, traders can control their risk and maybe make money in the long run.

Calendar spreads must, however, be approached with due thought and market research. Furthermore, using sophisticated options trading strategies can be made more effective by working with a trustworthy partner like Kotak Securities. To maximise profits using calendar spreads, keep in mind that cautious risk management and a good understanding of market patterns are essential.

FAQs on Calendar Spread

A calendar spread can be considered a low-risk strategy. It involves simultaneously buying and selling options with different expiration dates, limiting potential losses while offering moderate profit potential.

The optimal application of calendar spreads is to profit from the mispricing of futures of two different contracts as a result of divergent market expectations.

In options strategy with risk-defined parameters and limitless profit potential is the call calendar spread. Call calendar spreads have neutral to bearish short-term sentiment and a modest long-term bullishness.

Calendar spreads combine the advantages of spreads and directional options trading in a single position, making them suited for any market environment and an efficient option strategy to reduce market volatility.

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