Short Put Calendar Spread Options Strategy

Submitted by admin on Fri, 11/26/2021 - 18:16

This technique capitalizes on the distinctions between near- and long-term put options.


A short put calendar spread is formed by purchasing one put option and selling a second put option with a later expiration.
The approach is most frequently used with identical strike puts (horizontal spread), although it may also be used with various strike puts (diagonal spread).

Outlook


The investor is expecting for a significant rise in either direction in the underlying stock or a sharp decline in implied volatility throughout the life of the near-term option.

Summary


This technique capitalizes on the distinctions between near- and long-term put options.
If the underlying stock remains constant, the approach will experience time decay.
If the stock makes a dramatic move either up or down, both options will move closer to their intrinsic value or to zero, closing the gap between their values.
If the strike prices of both options are the same, the strategy will always get a premium upon commencing the position.

 

EXAMPLE

  • Long 1 AAPL near 160 put
  • Short 1 AAPL far 160 put

 

GAIN MAXIMUM


Received a net premium


LOSSES ARE LIMITED TO THE MAXIMUM


Net premium received - strike price (substantial)


Motivation


Profit from a rapid increase in the price of a stock.

Variations


The technique outlined here is a horizontal spread between two puts with the same strike price but different expiration dates.
A diagonal spread, on the other hand, would have a somewhat different profit/loss profile, as it would involve two puts with separate strikes and expirations.
However, the fundamental notions would remain applicable.

Maximum Loss


Should the underlying stock stay unchanged, the maximum loss would occur.
If the stock is trading at the strike price of the expiring option at the time of expiration, the expiring option will be worthless, but the longer-term option will retain a significant portion of its time premium.
In such case, the loss is equal to the cost of repurchasing the longer-term option less the premium earned when the position was begun.
If the near-term option expires worthless and the investor does nothing, the strategy reverts to a naked put, with the risk of loss limited only by the stock's inability to fall below zero.

Maximum Gain


The biggest profit would come if the two options were to equalize.
This may occur if the underlying stock increased sufficiently to render both options worthless, or if the price sank sufficiently to render both options deep in the money and trading at their intrinsic value.
In either situation, the gain would be equal to the premium earned when opening the position.

Profit/Loss


Profitability is restricted to the amount to which the near-term option increases in value faster or drops in value more slowly than the longer-term option.
The possible loss during the life of the near-term option is a function of implied volatility, and a quick increase in implied volatility might result in considerable losses.
If the position is kept through the expiry of the near-term option, the strategy devolves into a naked put with no additional profit potential and the potential for significant losses.

Breakeven


Due to the fact that the options have varying times to expiry, the point at which the strategy breaks even is a function of the underlying stock price, implied volatility, and time decay rates.

Volatility


Increased implied volatility, on the other hand, would be exceedingly detrimental to this approach.
Longer-term options, in general, are more sensitive to fluctuations in market volatility, i.e., have a larger Vega.
Bear in mind that near- and long-term options may trade with varying implied volatilities.

Time Deterioration


Time, on the other hand, would have a significant detrimental effect on this method.
In general, the rate of time decay of an option rises as the expiry date approaches.

Assignment Danger


While early assignment is available at any time, it is normally reserved for put options that expire deeply in the money.
Should the near-term option be exercised early, funding a long stock position for one business day would be required to cover the assignment (assuming it has not expired).


Additionally, bear in mind that a circumstance in which a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, may radically deviate from usual expectations for early exercise of stock options.

Risk of Expiration


The strategy's expiration risk occurs when the longer-term option matures.
The largest risk associated with this position arises if it is kept beyond the expiry of the near-term option, at which point it becomes a naked put.
By comparison, the risk of being unexpectedly allocated when the longer-term option matures appears to be rather insignificant.

Comments


Due to the difference in the time remaining to expiry of these two put options, their Theta, Delta, and Gamma values are different.
Clearly, the near-term put is more susceptible to temporal decay, i.e., has a larger Theta.
While the near-term put frequently has a smaller Delta, it may have a greater Gamma (if the strike is at-the-money).
This means that if the stock falls significantly, the near-term put becomes much more price sensitive and approaches the value of the more costly longer-term put.