Calendar Ratios

By Rick Fortier

My experience with calendar spreads would be that sometimes the stock will go beyond the profit zone of the calendar. As you know, calendar spreads are trades which are usually done when there is a skew, or difference between the front month and the back month options of a particular stock. This skew develops when there is a lot of uncertainty in the stock price. All of the options in that stock’s option chain have an increased implied volatility, but the months closest to their expiration will have a higher implied volatility than the more distance options in the same option chain.

Here is an example of a stock which has a skew between the front and back months.

So if the stock closes between 35 and 47 on expiration day in December then we will have a profit.

But the problem is that these stocks can move around erratically and frequently will move beyond the outside of the profit range. So I began to explore ways to lessen my chances that the stock movement will ruin my trade. This can be a movement to the upside or the downside. So my example of a way to minimize the risks that calendars have was to create a ratio calendar. To buy a higher number of options in a calendar spread than I sold. The extra call, or calls would cause the upper leg raise up to be near or above the breakeven line.

You have to experiment with the right ratio. Keep experimenting with the ratio until the risk graph looks right. You want to add calls (assuming a call calendar spread) until the right leg is above zero. Of course these extra “insurance” calls will add to the cost of your trade, but they will save your trade if you are wrong about what the stock will do, at least on one side of the trade. Later in this document I will show you how to protect both sides of the break even. For this particular trade, adding one additional call will cause it to be above zero.

And of course buying more calls will raise the leg even more, and increase your amount at risk too. There is a tradeoff for everything.

Notice that as the right hand side of the graph goes up, the left side goes down. The graph pivots like a see-saw with each additional call that is added.

Calendar ratio spreads are done when there is a skew between the front month and back month. You have to decide which way the stock will go if it breaks out. They still have a sweet spot of the trade which will be at the strike amount. In this case, the sweet spot is at 40. Notice that the blue line, representing today is similar to the risk profile of a call option. Below is the same risk graph but only showing today’s blue line.

Diagonal Spread

Now here is another way to get a similar effect, to protect you on one side of the calendar legs, the diagonal strategy. This is sometimes called a vertical calendar because the strikes are different.

These examples in this document are just for illustration purposes. This risk reward on this particular trade doesn’t look very good. But the concept is what I am trying to illustrate.

In this example I am buying a slightly in the money call, and selling a slightly out of the money call. The concept here is that the right hand side of the trade is protected. Typically with diagonals you will sell the next strike which is further out. Think of them as bull call spreads and bear put spreads. In a call diagonal you will sell the strike above the long call, and with a put diagonal you will sell the strike below the long put.

This is a normal spread configuration, “calendarizing” a debit vertical spread. If you try to calendarize a credit spread, selling the far month and buying the near month, your broker will  see the far month as naked and will require a lot of margin.

What other types of trades can we calendarize? How about the ratio backspread.

Calendar Ratio Backspread

This is one of my favorites. With a normal ratio back spread when you are completely wrong and the stock goes in the opposite direction, you will lose nothing. But if the stock only moves in the proper direction, but only a little, you lose money. Here is an example.

If the stock only moves to 45 I will have the maximum loss if I held it to expiration. The stock has to be above 51.20 for me to have a profit. Notice that the ratio I used here is somewhere in between a 1x2 and a 2x3. The lower the ratio, the better. If I had sold 6 and bought 9, then my break even would have been 54.20. A lower break even is much better. Okay, so much for the review on ratio backspreads.

So what happens if I calendarize this type of trade? Remember that we have to sell a nearer month option which has about twice the value of a further month option. So by necessity, the near month option must be in the money, and the far month will be at the money or out of the money.

I would like this trade very much if I thought that it was going to go up quickly. Notice that the ratio is 1x5. Obviously the rules on this type of trade are going to be much different than the normal ratio Backspread. Let’s notice an interesting fact on these kinds of trades if you manipulate them correctly. They become delta neutral. For a short price range, the trade makes money either way it goes. And on one extreme, in this example the left side, the reward is limited to the amount of the credit you receive. On the other side you have unlimited reward. But for a few price points on either side you are making very similar rewards. Let’s look at the risk graph with only today’s line on it.

Notice that between 15 and 19 that it is pretty much symmetrical. Try playing around with this strategy as an alternative to a straddle.

Final Thoughts

Now you can see how that by combining certain trade types you can achieve some nice effects. Take a look at the option strategies you know how to do already and play with risk graphs. Strategies which you know how to do at a 1:1 ratio look and see what effects other ratios have. Try looking at the bull call spread with 5 long and 4 short calls. Instead of a capped off reward, you will unlimited reward. Try doing a calendarized condor. Think outside of the box that your current knowledge limits you to. Look at the trades you know already, think about the risks of the trade (delta, gamma, theta and vega) and try to use other trades in combination with them to minimize some of those risks.

Well that is enough to think about for now. I hope that this article has gotten your grey matter busy. All of the charts displayed in this article are from my options trading program called OptimalTrader. One of the strategies is called the Ultimate Trade Finder. It will help you locate new strategies such as those I suggested in the prior paragraph. It can be used as a learning tool to help you think about ways to limit your risks. Visit my website at http://www.deltaneutral.com for details.

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