Today on Know Your Options, Liz & Jenny explain how to set up a call calendar spread the tastylive way. They exemplify this in IWM.
A call calendar spread is constructed by purchasing a long term OTM call, and selling a short term OTM call on the same strike against it. Doing so lowers the cost basis of the long call, and is viewed more as a volatility play than a directional play. Longer dated option prices are affected more than near term options in terms of volatility changes, which is why we view this as a volatility play. If volatility expands the profit in the long option will be greater than the marked loss we may see in the short option.
Since the long and short call are on the same strikes, at expiration the ideal scenario occurs when the short call expires just OTM, and the volatility is much higher than when the spread was purchased. This would result in a nice profit in the long call, and full profit in the short call that was sold. The trader can then take profits and run, or sell another call against the long call hoping for the same result.
Liz & Jenny start off the segment by explaining why this is a great beginner trade. A calendar spread is a defined risk spread, which means that your max loss is simply what you pay for the spread. Since we’re looking for a volatility expansion to realize profit, these spreads are best deployed in a low volatility environment.
When setting up the trade, Liz & Jenny explain that it is best to make the days until expiration (DTE) on the short call about 50% of the long call. This is ideal to deploy the short call multiple times, and also obtain a decent credit as well. Additionally, we always look to purchase an OTM calendar spread. Since we are selling a call against it and the long and short options share a strike, we want to keep the trade OTM.
Many times we may use this trade as a hedge, rather than an opening trade for an underlying. Hedging against other positions makes it easier for us to pick a direction and strike.
Tune in for a great discussion on calendar spreads, and how to set them up the tastylive way!
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