OPTION SPREAD TRADING

Comparing the Bear Call Calendar Spread with the Traditional Bear Call Spread

We have previously discussed the Bear Call Calendar Spread. So the logical question might be, “how does this compare with a ‘regular’ Bear Call Credit Spread?”

Below is a risk graph using exactly the same number of option contracts, only this time, all with October expiration dates.

See how it compares with the payoff diagram of the Bear Call Calendar Spread – see below.

bear call calendar spread
If we had only used October SPY options for both legs. Our upside breakeven would’ve been reduced to $118.59 and above that, falling away to a maximum loss of $1,400.

On the downside, however, our maximum profit would be $1,600 if the SPY closes below $117 at expiration date. This $1,600 would be the initial credit premium we received which we note is greater than for the bear call calendar spread at $1.60 per contract.

Since our choice of option trading strategies is really just a matter of risk vs reward over a range of strike prices up to a given expiration date, you would be more inclined to enter a bear call calendar spread if you believe the price action of the underlying will remain pretty much unchanged up to the last week before expiration.

You will receive the maximum profit potential this way. This strategy is therefore most suitable for a stock whose price action has low volatility over time. Consulting weekly and monthly charts will help you here.

Call Calendar Spread Example

In this hypothetical example, we’re looking at trading options on the QQQ in an imaginary situation where we believe that it will continue to rise over the next few months.

So with the QQQ trading at $106 we decide to sell (short) the nearest OTM options at $107 expiring in 20 days, while at the same time, purchasing $107 call options expiring in 50 days. The total cost is $0.69 per spread position and since we’ve taken 10 positions, the total debit is $690 plus commissions.

Now take a look at the image below, where we’ve analyzed the risk graph.

call calendar spread

You’ll notice that if the QQQ doesn’t rise above $108.78 before the near month expiration date, then a profit will be realized if both positions are closed simultaneously. But if the QQQ’s fall below $105.24 we begin to realize a loss, which falls away up until a maximum of the $690 cost of the debit spread. So this is definitely a calendar spread with a bullish outlook.

The maximum profit of $711 is realized if the underlying is sitting at the option strike price of $107 at expiration date.

Things to Look Out For

Before entering a call calendar spread position, make sure you check that there is not too much of a discrepancy between the option implied volatilty of the near term options compared to the longer term ones. If the longer term options are too over-priced, the deal may not be as sweet as you imagine.

Since this position is a debit spread, there will be no margin requirement with your broker. Margin requirements only come with positions where you receive a net credit upon entry.

Experiment With Strike Prices

In the second example below, we have taken a different approach. Instead of using $107 calls, we have chosen to go for $109 call options, which are further out of the money. So now our risk graph looks different – and our risk to reward ratio has also changed.

call calendar spread

This time, our position has only cost us $460 instead of $690, so that is our total risk. Our maximum profit on the other hand, has risen to $849, which is almost double our maximum risk. However, we need to believe more strongly that the price of the QQQ will rise in the near term because, unlike the $107 calendar position, there is no room for a fall in price before we start losing money.

Our upper level breakeven point however, has risen to $111.40.

Consequently, the further out of the money your call options are, the more it approximates a simple long call option position with a later expiration date, except that the entry price is reduced and the upside profit potential is also capped. This sounds like a bull call spread, except that if the price rises too much, too quickly, you begin to see a loss.

The Call Calendar Spread Explained

The call calendar spread, sometimes called the bull calendar spread, is an options spread strategy that is most suited to market conditions where you believe the underlying financial instrument is due to rise within the short term, but not by too much.

Over the longer term, however, the options trader is bullish on the underlying.

Here’s how the call calendar spread is constructed:

Sell 1 Out-of-the-money (OTM) call option with a near term expiration
Buy 1 Out-of-the-money (OTM) call options with a longer-term expiration

The idea is to reduce your entry price by selling the shorter-term options and with the intention of riding the longer-term call options for profit.

For this strategy to work, you don’t want the price action of the underlying to spike upwards before the short term option expires. These days, with weekly options, you can come up with all sorts of interesting combinations of expiration dates to make this work for you.

Your intention is also to take advantage of accelerating time decay on the OTM short options, as expiration approaches.

Expiration months on the call calendar spread can be anything from one month apart to whatever distance into the future you wish you place your bought options. Some people are happy to close both positions for a small profit at the expiration of the short options, while others would rather ride the long option into potentially larger profits over time. It all depends on your long term view of where the price of the underlying is expected to be.

Call Calendar Spread Example

Box spreads – An Easy Options Arbitrage Strategy

Box spreads are an option trading strategy that involves purchasing a bull-call spread along with a corresponding bear-put spread. The two vertical spreads have the same expiration dates and strike prices.

The idea is, that these two vertical debit spreads, each of which is designed to profit when the price of the underlying moves in either direction, create a “box” around the current trading price. A bull call spread normally profits when the underlying moves upwards, while the bear put spread does so when the prices falls.

So if you create two vertical debit spreads which, for want of a better expression, “face each other” on either side of the current market price of the underlying (the puts above and the calls below), you have effectively “boxed in” profits with options.

The thing to remember about debits spread however, is that profits are always limited to the difference in strike prices at expiration date, so the trick is to ensure that the cost of one of the debit spreads is sufficiently cheaper than the other, so that a profit can be realized.

There are times when option contracts are under-priced, usually due to current perceptions about the expected future price movement of the underlying market – for example, whether a trend has been exhausted and a reversal is imminent. So puts might be much cheaper than calls – and this is the ideal time to consider using box spreads.

Price distortions create opportunities which are known as “arbitrage”.

Most investors use this arbitrage strategy in cases where the spreads are under-priced in comparison to their values at the options expiry dates. The box spreads often combines two options pairs and it derives its name from the idea that prices are derived from a rectangular box in 2 columns of a given quotation.

Essentially, an arbitrageur is buying as well as selling equivalent spreads at the same time, on the proviso that the price paid for that given box is considerably below the combined value at expiration of the given spread, in which case a profit which is risk-free can be immediately locked in.

Expiration Value of the Box = Higher Strike Price less Lower Strike Price

Risk-free Profit = Expiration Value the of Box less Net Premium Paid

Some Assumptions Used in Box Spreads

1. The trader is risk averse
2. The trader prefers more wealth to less
3. Trade only happens in one trading period
4. The transaction and operation costs are zero
5. The investor has the ability to easily enter and exit the market and the market is efficient.

Box Spreads – An illustration

Suppose we are in December and a stock is currently trading at $45 and the current options prices for the month are:

JAN 40 put – $2.50
JAN 50 put – $8.45
JAN 40 call – $6.55
JAN 50 call – $5.50

Buying A bull call spread includes purchasing the JAN 40 call for $655 at the same time selling the Jan 50 call for $550.

The bull call spread costs: $655 – $550 = $105

Buying a bear put spread includes purchasing the JAN 50 put for $845 at the same time selling the JAN 40 put for $250.

The bear put spread costs: $845 – $250 = $595

The total cost of the box spread will be $105 + $595 = $700

The expiration value of the box is calculated to be: ($50.00 – $40.00) x 100 = $1000.00

Since the total calculated cost of box spread is much less than the expiration value, a risk-free arbitrage is probable with a box strategy implemented. We can observe that the value at expiration of our box spread example, is the difference between the strike prices of the options available during the trading period.

If ABC stock price remains unchanged at $45 at expiration date, then the JAN 40 put as well as the JAN 50 call expire worthless while both the JAN 40 call as well as the JAN 50 put expire in-the-money with a $500 intrinsic value each. Therefore, the total accumulated value of box at the date of expiration is: $500 + $500 = $1000.

Alternatively, suppose on the date of expiration in January, ABC stock price rallies to $50, so that only the JAN 40 call expires in-the-money with $1000 intrinsic value. Therefore, the box will still worth $1000 at the date of expiration.

What will happens when ABC stock plunges to $40? The same situation occurs but this time, it is the JAN 50 put which expires in-the-money with $1000 in intrinsic value while all the other available options will expire worthless. Remember still, the box spread is worth $1000.

As the trader you have only paid $700 for the whole box, so your profit will be $300.

Once you find these opportunities, you can just set and forget them until options expiration date. Unfortunately, the difficulty is in finding them. Floor traders often use them because they don’t pay broker commissions but for the retail trader, it is much more difficult. For this reason, the three legged box is a much better alternative.

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Bear Call Spread – Trading Calls When You’re Bearish

The bear call spread is an option trading strategy that is employed when you believe that the price of the underlying asset will fall at least moderately in the near term.

The bear call spread option strategy is also known as the bear call credit spread since a credit is received when entering the trade.

Bear Call Spread Construction

Buy 1 OTM Call
Sell 1 ITM Call

Bear call spreads can be implemented by buying call options of a certain strike price and selling the same number of call options of lower strike price on the same underlying security expiring in the same month.

Limited Downside Profit

The maximum gain attainable using the bear call spread options strategy is the credit received upon entering the trade. To reach the maximum profit, the stock price needs to close below the strike price of the lower striking call sold at expiration date where both options would expire worthless.

The formula for calculating maximum profit is given below:

Max Profit = Net Premium Received – Commissions Paid
Max Profit Achieved When Price of Underlying <= Strike Price of Short Call

Limited Upside Risk

If the stock price rise above the strike price of the higher strike call at the expiration date, then the bear call spread strategy suffers a maximum loss equals to the difference in strike price between the two options minus the original credit taken in when entering the position.

The formula for calculating maximum loss is given below:

Max Loss = Strike Price of Long Call – Strike Price of Short Call – Net Premium Received + Commissions Paid
Max Loss Occurs When Price of Underlying >= Strike Price of Long Call

Breakeven Point(s)

The underlier price at which break-even is achieved for the bear call spread position can be calculated using the following formula.

Breakeven Point = Strike Price of Short Call + Net Premium Received

Bear Call Spread Example

Suppose XYZ stock is trading at $37 in June. An options trader bearish on XYZ decides to enter a bear call spread position by buying a JUL 40 call for $100 and selling a JUL 35 call for $300 at the same time, giving him a net $200 credit for entering this trade.

The price of XYZ stock subsequently drops to $34 at expiration. As both options expire worthless, the options trader gets to keep the entire credit of $200 as profit.

If the stock had rallied to $42 instead, both calls will expire in-the-money with the JUL 40 call bought having $200 in intrinsic value and the JUL 35 call sold having $700 in intrinsic value. The spread would then have a net value of $500 (the difference in strike price). Since the trader have to buy back the spread for $500, this means that he will have a net loss of $300 after deducting the $200 credit he earned when he put on the spread position.

Note: While we have covered the use of this strategy with reference to stock options, the bear call spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).

Aggressive Bear Call Spread

You can enter a more aggressive bear spread position by widening the difference between the strike price of the two call options. However, this will also mean that the stock price must move downwards by a greater degree for the trader to realise the maximum profit.

Bear Spread on a Debit

The bear call spread is a credit spread as the difference between the sale and purchase of the two options results in a net credit. For a bearish spread position that is entered with a net debit, see bear put spread.

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Ratio Call Spread

The ratio call spread is an option trading strategy that is used when the trader believes that the price action in the underlying market will remain within a range that is at or above it’s current position, but won’t go too far north before option expiration date. It is part of the ratio spread family of positions because there is a disparity between the number of calls bought and sold, to make up the spread. The ratio can vary depending on the implied volatility in the option strikes and may include combinations such as 1:2, 2:3 or 2:5. The main idea is to enter the position at zero cost or even a small credit.

Here is an example of what a ratio spread might look like:

Ratio Call Spread Setup

Buy
1 ITM Call

Sell
2 OTM Calls

Ratio Call Spread – Advantages and Disadvantages

Since the position is usually put on at even money, the downside risk is generally zero, so the trader looks to realize a profit from low price volatility as the underlying meanders north as option expiration date approaches.

The downside of this strategy is, that once the underlying breaches the northern breakeven point, the potential loss is unlimited. The profit potential on the other hand, is limited. This is because you have sold more calls than you purchased and the point will come where their liability will outclass the value of the bought calls.

The maximum profit at expiration will be limited to the strike price of the OTM short calls, minus the strike price of the ITM long call, plus the net premium received (if any), less commissions. If a credit is received upon entering the position, the trader will make a small profit if the underlying falls or remains neutral until expiration. For this reason, ratio call spreads are ideal setups when you believe that the underlying has exhausted an upward trend and is unlikely to continue much further. Momentum indicators such as the RSI can be very useful in identifying these conditions.

Ratio Call Spread Example

Let’s imagine that a particular stock is trading at $43 in September. We believe that by October expiration date, the stock price will not travel much farther north, so we execute a ratio call spread strategy by buying one ITM October $40 call and selling two OTM October $45 calls. We do this for even money.

At expiration date, the stock is trading at $45. At this point, the October 45 calls expire worthless while the $40 call expires in the money and realizes a profit.

However, if at expiration date the stock price has advanced to $50 then all options positions will expire in the money. The trader now faces two $45 calls that are $5 in the money each and one $40 call which is $10 in the money. At this point, the trader breaks even.

But let’s say there was some unexpected good news for the company and the stock price shot to $60 by expiration date. Now we have a problem. The 2 sold $45 calls are $15 in the money while the one bought call is $20 ITM. So we are facing 15 x 2 = $30 liability vs $20 asset = $10 loss on the position, times the number of underlying shares covered by the option contract.

The above scenarios are depicted in the risk graph below.

We can see how beyond a certain point, the ratio call spread is liable for potentially unlimited loss. For this reason, I would prefer to use this strategy on Exchange Traded Funds options rather than individual company stocks, unless you are certain that nothing is likely to cause an unexpected spike in price.

The ratio call spread should not be confused with the call ratio backspread. Backspreads are used when future price volatility is expected while ratio spreads are executed in neutral market conditions.

Editor’s Note:– After Learning This Trading System You’ll Never See Options the Same Way Again!

Put Ratio Backspread

The put ratio backspread is an option spread trading setup that falls into the class of strategies designed to take advantage of upcoming price volatility.

Being a backspread, it profits from price breakouts. The risk of loss on the trade occurs when the price action of the underlying remains within a consolidation pattern, or returns to the loss zone as option expiration approaches.

Put ratio backspreads are also credit spreads, but unlike your regular credit spread where your profit potential is limited to the credit you receive, these backspreads have unlimited profit potential. So you get all the benefits of other backspread strategies such as the straddle, but you receive a credit instead of paying a debit for it.

Being a put spread, this strategy does have a directional bias though – you’re looking for a price breakout to the downside. However, if you construct them correctly, you can even make a small profit should the price break to the upside. If you want to take a bet both ways, so to speak, you can combine this strategy with a Call Ratio Backspread for unlimited profit to the upside.

The above is only one example of how a put ratio backspread may look. By experimenting with different combinations of short and long positions and examining the risk graph, you can come up with one that suits your objectives. The important thing is, that you buy more out of the money (OTM) puts than the ITM ones you sell – this is the ratio part.

Since the ITM options you sell will be more expensive than the OTM options that you purchase, providing the ratio is not too extreme, you should receive a net credit. As the price of the underlying falls, the ITM options will have a higher option delta than the OTM options and for a little while, increase in value at a higher rate. But once the OTM option strike prices have been breached so that they become in the money, the profit margin on these will outclass the sold options – and because there are more of them, you realize an overall profit.

Here’s what a typical put ratio backspread looks like:

The risk graph above assumes a ratio of 1 ITM options sold, to 2 OTM options bought.

The ITM short option strike price is $50
The OTM long option strike price is $47.50

You’ll see that, should the price of the underlying sail north, you still realize a small profit. If it remains within a range, you lose on the trade at expiration. But if it falls past the $45.46 breakeven point, your profit potential to the downside is almost unlimited.

However, if you had chosen to widen your short and long strike prices, the risk graph would reflect that. The closer your strike prices, the greater your potential profit to the downside, but you make less on the upside.

Best Time to Use a Put Ratio Backspread

Since you’re relying on price volatility, you should choose an asset that you expect to drop sharply in the short term. This may be due to a news event, an upcoming earnings report, or technical indicators such as price consolidation in an overbought price range. If you’re trading index related ETFs, it could be at the beginning of an overall pessimistic mood in the market which could be related to some political event or economic conditions.

The benefit of the put ratio backspread over buying simple put option positions is, that should your prognosis be wrong and the price of the underlying goes in the opposite direction to what you anticipate, you can still make some profit. It does however, make less profit than a simple long put option would for the same downwards price movement in the underlying.

Editor’s Note:- Once You Understand This Trading System You’ll Never See Options the Same Way Again!

Backspread Option Strategy

The backspread option strategy covers a number of setups, all designed to profit from volatile market conditions. Backspreads include strategies such as the Long Straddle, Long Strangle and Ratio Spreads where the implied volatility in the short positions is greater than the IV for the long positions.

Backspreads are the opposite of frontspreads, which are option strategies more suitable for neutral market conditions. Frontspreads include setups like the Iron Condor, the Butterfly Spread and Long Iron Butterfly, as well as the Short Straddle and Strangle. Frontspreads also include ratio spreads, which should not be confused with ratio backspreads.

Backspread Option Strategy – Taking Advantage of Volatility

The best times to employ backspreads is when you expect the price action in the underlying asset to become volatile in the near future. Fortunately, this is often highly predictable. The idea is to enter the backspread when the long (bought) positions are relatively cheap and the short positions (if applicable) are relatively expensive due to a higher implied volatility (IV) in the premium. As IV increases, which usually occurs when the underlying begins to move rapidly (though not necessarily so) your positions will show a profit. In most cases, the profit potential is unlimited.

There are many factors which can trigger volatility in price action. Upcoming earnings reports, news releases, court rulings, executive management changes and a host of other business events can affect the price of a stock. Some of these are predictable, others aren’t. Applying a backspread shortly before an event that may cause price volatility can realize wonderful profits.

Risks in the Backspread Option Strategy

Should the underlying asset price remain stagnant for a period of time, the value of your backspread will deteriorate. It is rare for stocks and commodities to remain stagnant for extended periods, but it does happen. If you’re using this strategy, you should first be aware of the maximum loss versus potential rewards. Fortunately, maximum potential losses can be precisely calculated for any backspread option strategy you choose. Pharmaceutical companies are often a good choice for the backspread strategy, particularly if a ruling is about to be made about the approval or otherwise of a new drug.

Iron Condor Setup

The correct iron condor setup can make all the difference between consistently profitable outcomes, rather than sometimes winning, sometimes losing, when using this popular option trading strategy.

So why is the iron condor so popular? The main reason would be that it’s a strategy that doesn’t require you to predict the future direction of the underlying. As long as the underlying asset remains within your predetermined price range within your chosen time period, you automatically realize a profit.

The second reason is, that unlike regular credit spreads, iron condors bring in twice the credit without your broker requiring any extra margin for the trade. The reason for the break they give you on margins is, that whatever happens after the trade is placed, only one side can ever lose.

But it’s not all an easy run to the bank. There are some important things that you need to remember before risking your capital on just any iron condor because when they go wrong, your potential losses can be much greater than your anticipated profits. So you need to choose your iron condor setup wisely.

The Secret to an Effective Iron Condor Setup

Here are a few things to consider before trading iron condors:

Profits are limited to the double-credit you receive.
Adjustments to the positions may be necessary, should the breakeven points be threatened.
The timing of your entry into the position is important.
The underlying financial instrument you choose is important.
The wider your breakeven points, the less credit you will receive compared to the capital you risk, but the likelihood of these points being breached is also reduced.

With the above in mind and depending on your own personal risk profile, we propose the following two Iron Condor setup suggestions:

Iron condor setup No. 1

This position should be placed on monthly options only and between 40 and 30 days before the option expiration date. You should aim to bring in a credit of at least 70 cents per contract.

As the time draws closer to the expiration date, the position should be monitored for potential breaching of the chosen range. Should this occur, adjustments should be made so that profit potential is maintained. Adjustments of this nature often narrow the breakeven points somewhat, which puts the position at greater risk of being breached as the option expiration date approached.

The position should be exited before expiration week arrives. The reasons why are explained in detail in the Trading Pro System training modules.

Iron Condor Setup No. 2

Our second proposal has a very low probability of becoming unprofitable – but the trade-off is, that you don’t receive as generous a profit either. So if your trading approach is, that you’re happy with a 10 – 15 percent return on risk per month, with a view to growing your capital slowly by compounding it, this strategy is for you.

Here’s how it works.

You place an iron condor trade in the usual way, except that your “sold” positions must have a delta of around 0.10 give or take a point or two. This effectively means that your short positions will only have about a 10 percent chance of being breached and therefore, a 90 percent chance of success.

An Iron Condor setup done this way will have a very wide range for profitability. This is its major advantage. If you compare this range with a chart of the underlying, you’ll see that the likelihood of it failing is quite remote. Even if the breakeven points are in danger of being breached, you can always adjust, providing there is enough time left before expiration to maintain a reasonable profitability level. You will quite often be able to let these positions expire worthless and realize the full profit potential of the credit you’ve received.

If you combine this iron condor setup with the right choice of the underlying asset, your likelihood of success is even greater. The best stocks to use this strategy on, are Exchange Traded Funds (ETFs) rather than individual company stocks. The reason is, that their portfolio of shares and derivatives are designed to mimic the performance of an index. Since indexes don’t have huge price action gaps, they are a much safer option for this strategy.

For further information about using Iron Condors for monthly income, the people who designed the popular Trading Pro System have produced a series of videos that explain it all in detail, together with a number of other advanced strategies for long-term wealth creation.

Which is the Best Iron Condor Strategy?

Iron Condor Strategy

The Secret to an Effective Iron Condor Strategy

The right iron condor strategy can make all the difference between consistently profitable and sometimes winning, sometimes losing, results when using this popular option trading strategy.

So why is the iron condor so popular? The main reason would be that it’s a strategy which doesn’t require you to predict the future direction of the underlying. As long as the underlying asset remains within your predetermined price range within your chosen time period, you automatically realize a profit.

The second reason is, that unlike regular credit spreads, iron condors bring in twice the credit without your broker requiring any extra margin for the trade. The reason for the break they give you on margins is, that whatever happens after the trade is placed, only one side can ever lose.

But it’s not all an easy run to the bank. There are some important things that you need to remember before risking your capital on just any iron condor, because when they go wrong, your potential losses can be greater than your anticipated profits. So you need to choose your iron condor setup wisely.

Here are a few things to consider before trading iron condors:

1. Profits are limited to the double-credit you receive.

2. Adjustments to the positions may be necessary, should the breakeven points be threatened.

3. The timing of your entry into the position is important.

4. The underlying financial instrument you choose is important.

5. The wider your breakeven points, the less credit you will receive compared to the capital you risk, but the likelihood of these point being breached is also reduced.

With the above in mind and depending on your own personal risk profile, we propose the following two Iron Condor setup suggestions:

Iron condor Strategy No. 1

This position should be placed between 40 and 30 days before option expiration date and bring in a credit of at least 70 cents per contract.

As the time draws closer to expiration date, the position should be monitored for potential breaching of the chosen range. Should this occur, adjustments should be made so that profit potential is maintained. Adjustments of this nature often narrow the breakeven points somewhat, which puts the position in greater risk of being breached as option expiration date approached.

The position should be exited before expiration week arrives. The reasons why are explained in detail in the Trading Pro System training modules.

Iron Condor Strategy No. 2

Our second proposal has a very low probability of becoming unprofitable – but the tradeoff is, that you don’t receive a generous profit either. So if your trading approach is, that you’re happy with 10 – 15 percent return on risk per month, with a view to growing your capital slowly by compounding it, this strategy is for you.

Here’s how it works.

You place an iron condor trade in the normal way and between 35 – 30 days before expiration – except that your “sold” positions must have a delta of around 0.10 give or take a point or two. This effectively means that your short positions will have about 10 percent chance of being breached and therefore, 90 percent chance of success.

An Iron Condor strategy done this way will have a very wide range for profitability. If you compare it with a monthly chart of the underlying, particularly broad based indexes or their related ETF’s, you’ll see that the likelihood of it failing is quite remote. Even if the breakeven points are in danger of being breached, you can always adjust, providing there is enough time left before expiration to maintain a reasonable profitability level.

If you combine this iron condor strategy with the right choice of underlying asset, your likelihood of success is even greater. The best stocks to use this strategy on, are Exchange Traded Funds (ETFs) rather than individual company stocks. The reason is, that their portfolio of shares and derivatives are designed to mimic the performance of an index. Since indexes don’t have huge price action gaps, they are a much safer option for this strategy.

For further information about using Iron Condors for monthly income, the people who designed the popular Trading Pro System have produced a series of videos that explain it all in detail, together with a number of other advanced strategies for long term wealth creation.

How to Manage the Diagonal Spread

The Diagonal Spread – The Best of Both Worlds

The diagonal spread is one variation of options spread trading that has been used most effectively to adjust existing spread positions.

It is called by this name because unlike regular vertical spreads where you go long one strike price and short another – the diagonal spread includes the extra dimension of different expiration dates.

If you think of expiration dates as the horizontal aspect of option spreads and the different strike prices as the vertical aspect, then combining the two is what creates the “diagonal” effect – and hence the name.

This strategy uses the same type of options contract – i.e. all calls or all puts. The most appropriate application is going short (selling) the front month and long (buying) the later expiration month in order to take advantage of option time decay. Since ‘out of the money’ front-month options will expire at a greater rate than the later month options, this is where the advantage lies.

Since you are shorting the nearer month expiry and buying the later month, the greater time value in the later month premium will mean you will receive less credit than you would from a regular vertical credit spread. So you should take into consideration the implied volatility in the later month options as well as the distance between the strike prices, as part of your strategy.

If your diagonal spread is entered with both strike prices ‘out-of-the-money’ the ideal scenario is that the price action of the underlying security will trade closer to, but won’t breach, the short strike price by the time it expires. If this happens, you will keep all the short option premium but still retain a long position which is now closer to the money and with another month or more time value still remaining.

Depending on the difference between expiration months and the length of time it has taken for the underlying to trade to this level, it is quite likely that the long position is also now more valuable and can be sold for maximum profit.

The above works particularly well with put options because increased implied volatility usually inflates put option prices when fear overtakes the market. So the back month, long position, has better value.

But if the price action of the underlying falls away from the closer short strike price, you simply get to keep the overall credit received when you entered the position.

Diagonal Spread Example

XYZ company shares are currently trading at $45 and you wish to construct a call diagonal spread position.

Sell (short) 10 XYZ $50 January call options for $5
Buy (go long) 10 XYZ $55 March call options for $1

You receive an overall credit to your account of $4

You’ll notice the vertical aspect is a $5 difference in strike prices and the horizontal aspect is a 2-month difference in expiration dates.

If the price of the underlying trades up to $50 at the front-month expiration date, you get to keep the $4 credit you received. At this time the later month $55 long call option will now be worth more, being closer to the money but with remaining time value (let’s say $2.50) so you can choose to sell this for an overall profit of $6.50 times the number of shares covered by the option contracts.

You have risked $1 being the difference in strike prices ($5) minus your initial credit ($4), to make $6.50. This scenario gives an excellent risk-to-reward ratio.

The diagonal spread can be adapted to both debit and credit spreads, each with its own risk to reward ratio. You can adapt them to the following vertical spreads:

The Diagonal . . .

Bull Call Spread

Bear Call Spread

Bear Put Spread

More comprehensive information about diagonal spreads, calendar spreads, and double calendar spreads, including how to “trade by the numbers” using the option “greeks” can be obtained from a series of downloadable videos obtainable from the Options Trading Pro System.

diagonal spreads

The Double Calendar Spread

A double calendar spread can be either a combination of the strangle or straddle option strategy along with the principles of calendar spread trading.

A strangle option is where you simultaneously purchase an equal number of call and put options, but both positions having strike prices that are out-of-the-money at the time of entry.

Never Underestimate the Power of a Double Calendar Spread

We now take this principle and add to it another dimension. To turn a strangle position into a double calendar spread, we simply ensure that our bought (long) options have an expiry month further out than the options we are about to sell.

For example, let’s say we are entering our position in May of some year. We would buy an equal number of JULY call and put options at strike prices, say $5 apart (let’s assume $25 puts and $30 calls). To this setup we now add the SALE (going short) of the same number of calls and puts, but with JUNE expiry dates. So in the case of our example here, we would sell June $25 puts and also June $30 calls.

Should the underlying price action subsequently explode beyond the $25 or $30 levels, one of your short options will increase in value while the other will decline. At this point you could choose to buy back your losing ‘sold’ option for next to nothing and continue holding the losing long position. Your other ‘sold’ option that would ordinarily expose you to unlimited risk will be protected by your longer dated bought option, since they have the same strike price.

The same principle can be applied to convert straddles into a double calendar spread. Only in this case the strike prices are all the same.

Double Calendar Spread – Criteria for Entry

Before you consider placing a double calendar spread, there are a couple of things you need to see in both the underlying and the options themselves. You should believe that the underlying stock will remain within a trading range for the duration of your short options’ lifespan – so in our example above, until June expiry date.

But here’s the real important one. You should also look at the options implied volatility for both the near month and later month options. You look for what is called a “volatility skew“. These occur when the near month options have an higher implied volatility than the later month options. Since you want to sell the near month options, you would like to receive as much as possible and this is why you look for these skews.

If you notice a volatility skew, it could possibly signal an upcoming earnings report. Since these can produce unpredictable results for stock prices, you should first check that an earnings report is NOT on the horizon before placing the double calendar spread trade. If the volatility skew is a natural one and shows at least a 2 percent difference, you have a good candidate for entry.

Analyzing the Double Calendar Spread

Before executing your double calendar spread, the final thing you need to look at is a risk profile graph. The risk graph will show a range of stock prices at which the position will make a profit. Ideally, the current market price of the underlying at time of entry should be in the centre of the risk graph. This will allow you enough movement to the upside or downside before your breakeven points are breached and any adjustments may be necessary.

Analyzing the double calendar spread payoff diagram.

The beauty of this position is that because you are on the selling end of options contracts, you have ‘theta’ or ‘time decay’ working in your favour. Maximum profits are achieved when your near month options both expire worthless because ‘at-the-money’ while your long dated options still have enough time value to close the whole position for a profit.

Enjoy This Video About Double Calendar Spreads

Learn How to Adjust Calendar Spreads With the Options Trading Pro System

Bear Put Spreads Option Strategy Explained

Bear Put Spreads – Profit from Falling Prices

What is the difference between bear put spreads and bear call spreads, for example? Do you understand why they are each called by that name? This is all about getting our options trading terminology correct.

Here’s how it works.

The first word in the phrase indicates your view of the market. So a bear put spread would indicate that you believe the underlying stock in question is about to take a price dive. In other words, you’re bearish on the stock, so your vertical spread strategy will reflect that.

The next part of the expression indicates not only the type of spread you are going to do, but when combined with the bearish nature of your view of the stock, the fact that it will be a debit spread (not a credit spread). If you were doing a credit spread, you would want the underlying to remain away from the spread strike prices until the option expiry date for it to be profitable.

But for a debit spread, you would ideally like it to plunge through both strike prices for maximum profit.

Bear put spreads are option debit spreads that are structured by buying put options with a strike (exercise) price that is close to the current market price of the share … and simultaneously selling the same number of put options at an exercise price that is lower than the bought options.

Since the bought options will be more expensive (being closer to the money) than the sold ones, the net result is a debit to your brokerage account – hence, the “debit spread” part of the trade.

Since we enter put debit spreads because we believe we can make a significant gain if the underlying price falls, they provide a way of entering a greater number of option positions at less cost than simply buying (going long) puts.

They also allow greater flexibility should the underlying price temporarily go against us, in that we can consider buying back the ‘sold’ position for a fraction of what we sold it, in the hope that should the stock resume its downward trend, we will profit from the remaining bought put option, which we now own at a tremendous discount.

Bear Put Spreads – Profit Potential

Your maximum profit on these debit spreads will be the difference between the strike prices at expiration date, less the net premium (debit) you paid to enter the spread. For this to occur, the price action of the underlying will need to be at, or below, the strike price of the further out-of-the-money sold option. You can, of course, take a lesser profit at any time up to the time the options expire.

This strategy should be distinguished from the bear call spread. The latter are credit spreads, again the result of a bearish view of the market but comprised of call options in the hope that the underlying stock will remain away from their strike prices. More on that on another page.

bear put debit spread

The Bear Call Calendar Spread Option Strategy Explained

Using the Bear Call Calendar Spread to Your Advantage

The bear call calendar spread is a combination of the option credit spread and calendar spread strategies. It is simply a credit spread but with an expiration date variation. You will have one leg of the position expiring in the front (nearest) month, usually between 30-45 days, and the other leg in a later (back) month.

The front-month position will be short (sold) and the later month, long (bought). Both legs will contain an equal number of options positions.

The strike (exercise) price of the front-month call options will also be lower than the back month call options

Bear Call Calendar Spread Example

Let’s say the overall market has turned bearish and we are interested in trading options with a bearish strategy on the SPY – the Exchange Traded Fund (ETF) which mimics the S&P 500 index. We decide upon a bear call calendar spread as follows:

Sell October SPY $117 call options
Buy November SPY $120 call options

Credit Received = 47 cents per position
We take out 10 positions for a total $470 credit.

We then analyze the above position which produces the following risk graph.

bear call calendar spread

Observations:

Our upper breakeven point is $22.38 which means the SPY can rise to that level before we start losing money. Above that, our loss sets in and falls away to a maximum loss of around $2,500 once the SPY cracks above $160.

On the downside, our maximum profit of $2,500 is achieved if the SPY closes at $117 on the October expiration date. If the SPY falls lower than 117 before then, our profit gradually tapers off but will always be no less than our original $470 credit received when we initiated the transaction.

So this is definitely a bearish option spread trading strategy, but with an upside that is protected by our longer-dated call options.

Comparing the Bear Call Calendar Spread With a Bear Call Credit Spread

Iron Condor

When To Take Profits on an Iron Condor

The iron condor is a favorite among traders because, being a double credit spread, you receive twice the premium but on margin for only one side of the trade. Being a range trading strategy, all you really want is for the underlying to remain within the range until expiration date and you keep it all … right?

But it isn’t as simple as that.

One trap that iron condor traders fall into, is that they wait until it’s too close to expiration date before exiting the position. By this time, your ability to adjust the trade has been compromised by a combination of theta time decay on your out-of-the-money positions and intrinsic value on the sold options for the side of the trade that is under threat of being breached. Late adjustments will result in a much narrower range if the same profitability is to be maintained. A narrow range with a short time to expiration can be quite precarious.

One solution is to close a portion of your positions and secure some profit when the underlying is in the “sweet spot” or optimal position on your risk graph (i.e. the mid-point of the range). This frees up capital to deploy elsewhere, while at the same time, offsetting any potential losses on the portion of the original trade that you didn’t close out.

A better solution is to understand that by adjusting your positions just once a couple of weeks into the trade, you not only take some profit out of the market, but at the same time, re-position your “sweet spot” into the middle of the range, allowing you to collect further profits from accelerating option time decay. This is one of the techniques they teach you (among other things) in the Trading Pro System series of videos.

The best time to enter your original iron condor trade, is between 40 and 30 days till expiration. Here, you can usually get a nice wide spread and at least 70 cents credit per underlying share covered by the options. This is what you want – plenty of room for the underlying to move around in. Your theta (time decay) graph will also have a nice broad curve to it. This allows the underlying to move further while still showing a paper profit. Draw your channel trendlines on the underlying first to make an assessment where it might possibly go within the next few weeks and establish your iron condor range around it.

When to Exit an Iron Condor Trade

It is not advisable to remain in the trade after you’ve passed the halfway mark in terms of total time to expiration from original entry. Don’t be greedy! The halfway mark offers the best time/risk/reward ratio, assuming price and volatility are not on the move. If you’re in the “sweet spot” (midpoint) around this time, you can usually collect about 70 percent of your total potential profit. This is a good deal – 50 percent of total time for 70 percent of total profit. Take profits and start over with something else. If you stick around in the hope you’ll grab that little bit extra with less than two weeks to expiration, time decay and price volatility can ruin you.

Bottom line:- don’t ever let your “time in the trade” percentage exceed your “total potential reward remaining” percentage. Seventy percent time in the trade for only another 20 percent potential reward is not a good deal.