Boss-Level Calendar Spread Management

Calendar spreads involve both buying and selling options with different expiration dates. Sometimes, they will also have different strike prices. An example of this is the Poor Man's Covered Call (PMCC). 

The goal of a calendar spread is to have the short contract expire OTM so that you can realize the full premium from shorting it. Or, you can choose to take profits early.  Your long option does not suffer from as much theta decay and retains value better than the short leg. Typically, you will buy a call or put expiring in the distant future, and then sell the same type (call or put) expiring in the near future. 

Calendar spreads come in several forms:
Same Strike but different expiration: horizontal spread
Different strike and expiration: diagonal spread

Calendar spreads in all their forms are popular because they require less buying power than most other strategies. Calendars are ideal for accounts in the $25,000+ range so that Pattern Day Trade rules are not problematic.

In this post, we will discuss how to determine the effects of stock price and the Greeks on your position. We will also discuss how to manage your calendar spread when your Greeks get out of whack. This post will focus on call calendar spreads for simplicity, but the same concepts exist on the puts side.

Effects of Delta

When you trade a call calendar spread, you want to be delta positive. That is, you always want the call that you bought to have a higher delta than the call that you sold. That way, you continue to make money if the stock rises.

The PMCC is a good example of this. In a PMCC, you buy a long call expiring in the distant future and use it as collateral to sell covered calls expiring in the near future. This is advantageous over traditional covered calls because the long call is much less expensive than 100x shares, and therefore you do not need as large of an account to use this strategy.

To determine your level of delta-ness, check the difference delta difference between your short and long calls. 

Bought-to-open 120-DTE $100 call at 0.80 delta.
Sold-to-open 30-DTE $120 call at 0.30 delta.

In the above position, the trader has a long delta of 0.80 and a short delta of 0.30. The equates to a total long position of 0.50 delta. When the underlying stock rises $1, the long call will gain ~$80 in value, and the short call will lose ~$30. The trader will have gained $50 in total.

However, we know that these neat and tidy deltas don’t last, and each leg’s delta will shift as the stock changes in value. We will explore this in the Gamma section.

Managing delta: When we trade call calendar spreads, we have the underlying expectation that the stock will go up. Therefore, we want to maintain a positive delta position at all times.

If the stock were to move sharply higher, we run the risk of our short call rising in delta faster than our long call. This is due to gamma effects, which we will explore in the next section. What do we do if a week later when the underlying moons, our new position looks like this:

Long $100 call: 0.90 delta
Short $120 call: 0.96 delta

In this case, the trader is now losing $4 for each dollar XYZ rises higher still. He is now losing $96 on the short call, and gaining $90 on the long call.

Most of the time, this is acceptable. Since there are is a $20 strike difference between the long and short calls, the long call has a “head start” of $2,000 of value over the short call. The trader will have a substantial gain on the long call, and it is unlikely that the short call will outpace all of its value change.

However, if you are now short 0.20 delta on a call calendar spread, it may be time to modify your position. Your choices are as follows:

(1) Roll your short call up and out. If you can buy back your short call and roll another 30-DTE out, you will pull some additional premium and reduce your short call’s delta. Even better, if you can roll to a higher strike, you will “lock in” additional gains on the long call and dramatically decrease your short delta.

Keep in mind you may not be able to roll to an ATM strike. As long as you can roll up at all, you will drop your short delta.

(2) Close the whole spread. If you selected an adequately high delta on your long call, you are at very little risk of going into the negative deltas by more than a few points. If that were to happen, you would almost certainly have made more money on your long put than you lost on your short put. Closing the whole spread would award a handsome gain.

If you want to continue trading the stock, you can then reset a new PMCC to the traditional 0.80/0.30 delta setup.

Effects of Gamma

Gamma describes how fast your delta gains or loses value. For each dollar the stock rises, the delta will likewise change by the value of gamma. If you’re a physics student, gamma is the second derivative of price, whereas delta is the first derivative.

When we trade call calendar spreads, we are typically negative gamma. This is unfortunate, but it is largely unavoidable.

Bought-to-open 120-DTE $100 call at 0.80 delta, 0.002 gamma.
Sold-to-open 30-DTE $120 call at 0.30 delta, 0.09 gamma.

Since options expiring in the near-term have higher delta than options expiring in the long term, and delta cannot go above 1.00, then your short call will certainly have a higher gamma than your long call.

This gamma shift causes us some pain on the delta side. While our delta gap is starting at 0.50, this gap will tighten as the stock rises. Soon, we will have 0.48 delta between our calls. Then 0.45, and so on. As the stock rises, we will make less money on each uptick than we did on the previous. Likewise, a secret Greek called “speed” will push the short call’s gamma up as the stock rises, meaning the delta gap will close at a faster rate with each uptick.

If the stock rises high enough, our short call’s gamma will have forced its delta above that of our long call. We will begin losing money with each subsequent uptick in price.

Managing gamma: We will never be in a long-gamma situation when selling call calendar spreads. Our long call’s gamma will always be lower than our short call’s. However, we can take some steps around expiration to make sure that our gamma exposure remains acceptable despite being negative.

(1) An ATM strike close to expiration will have high gamma, delta will rapidly shift in either direction due to another secret Greek called “charm.” Charm jerks delta up and down as the stock’s price shifts across the strike in the final days before expiration.

To avoid both gamma and charm sending our delta spiraling, it is common practice to roll your short call within 14 days of expiration. Especially if you are looking at a gain, rolling your high-gamma short call to a later expiration will prevent you from holding the option during the time period in which the risk of your deltas inverting is highest.

(2) Buy a deep OTM call for some extra gamma. If you have the conviction for it, taking on a very deep OTM call will offer you some gamma protection in case the stock takes off. Keep in mind you will have to pay for this call, so it will dig into your profits from selling short calls.

Effects of Theta

Theta is the Greek that eats away at the value of an options extrinsic value over time. For each day that passes, the contract will lose the portion of extrinsic value indicated by theta.

Theta starts really kicking close to expiration, so your short call will always have a lower theta than your long call unless the short call is really far OTM. In that case, the contract would have such little value that there is nothing for theta to eat.

With the exception of the extremely deep OTM short calls (delta <0.02), you will always be theta positive and benefit from the passage of time. This is largely the point of calendar spreads.

Bought-to-open 120-DTE $100 call at 0.80 delta, 0.01 theta.
Sold-to-open 30-DTE $120 call at 0.30 delta, 0.04 theta.

In the above trade, the trader is losing $1/day to theta on his long call, but he is gaining $4/day on his short call. This is because the extrinsic value on the short call is losing value faster than on the long call. The trader is theta positive.

Managing theta: You should expect to always be theta positive when trading call credit spreads. However, if you do wind up being theta negative or close to theta even, then you should adjust. If you are not theta positive, then you are losing money to the passage of time, and very likely, your short call is almost worthless anyway.

(1) Take gains on the short call and reopen a new short call ~30-45 DTE and 0.50 delta lower than that of your long call. This will add more extrinsic value and theta to your short call so that you can start benefiting from the passage of time again.

(2) Sell a new short call as above, but keep the old short call open and allow it to expire. This will expose you to risk if the stock swings back up, but if you believe that is unlikely, you can save yourself a few dollars by not closing the short call early.

Effects of Vega and volatility

Vega is the Greek that describes how much a contract’s value will change for each 1% change in volatility. This is one of the most complicated Greeks to understand fully. Remember that a stock that whips wildly in either direction (like MARA) will have a higher level of volatility than a stable stock (like BAC). Options on highly volatile stocks like MARA will suffer IV-crush heavily if volatility were to drop for any reason. Options on low-volatility stocks like BAC don’t have a lot of value to lose to vega, but if volatility were to rise, then vega would dramatically push up the value of the contract.

In terms of calendar spreads, we will usually be vega positive. If the stock’s volatility rises, the long call will climb in value because the stock has a lot of time remaining to swing even further. The short call’s value will also rise due to rising volatility, but since expiration is close, that does not leave a lot of time for the stock to move further. Therefore, the price will rise less than it does on the long call that expires later.

Therefore, call calendar spreads are almost always volatility-positive when we initially set them up.

Bought-to-open 120-DTE $100 call at 0.80 delta, 2.31 vega.
Sold-to-open 30-DTE $120 call at 0.30 delta, 1.31 vega.

For each point volatility increases, the trader should expect to make $100. His long call will rise in value by $100 more than he is losing on his short call.

Managing vega: But there is one problem- vega changes at different rates due to another Greek called DvegaDtime (second derivative of volatility whereas vega is the first derivative). DvegaDtime (derivative of vega with respect to time) is also called “veta.”

It is not necessary to understand the math. All we need to know is that vega will move rapidly in either direction when a stock is ATM and close to expiration.

If we are holding an ATM short call near expiration, then we must be prepared to lose money as volatility increases. DvegaDtime will push vega up on the short strike more powerfully than it will on the long strike. As a result, our vegas may flip.

Once vega flips, we will start losing money for each additional increased point in volatility. Fortunately, we should be able to predict when something like this will happen. It will almost certainly be because news is pending, such as an earnings report. We should expect implied volatility (IV) to increase dramatically right before earnings, so our vegas are liable to flip. We may or may not want to adjust:

(1) If we are playing IV crush and intend to hold through earnings, it may not be necessary to make an adjustment at all. Upon IV crush, the increased vega will evaporate, wiping out any vega-induced losses.

(2) If we are concerned that the earnings report will be dramatic in either direction, IV crush may be minimal. In that case, vega-induced losses will stick. To mitigate this, consider either closing the spread prior to earnings.

If you insist on holding a calendar spread through earnings on a volatile stock with an ATM short strike near expiration, consider buying some deep OTM long calls or puts as a hedge against a rapid price swing or lack of IV crush.