Using Calendar Spreads to Profit from a Bear Market

Calendar spreads, also known as time spreads, are useful when you are uncertain about the direction of the market but you want to implement an effective option hedge during periods of market volatility. Of course, you can tailor your calendar spread to meet a bullish or bearish bias, and we will be looking at calendar spreads with a bearish bias in this article.

A bearish calendar spread consists of two options: a long put option and a short put option.

Long put option: The first option is a long put with a long-term expiration date. Traders will usually use LEAPS or options with expiration dates longer than a year for this option. The long-term put establishes the bearish bias for the trade and will grow in value as the market drops.

Short put option: The second option is a short put with a short-term expiration. The short put has the same strike price as the long put you purchased. The identical strike price but different expiration dates is what makes this a calendar spread.

When you enter a bearish calendar spread, you must pay for the long put option but you receive a premium for selling the short put option. The ratio of the premium received from the short put to the price you paid for the long put is much larger than the ratio would be in a diagonal spread—where you do not buy and sell options with the same strike price. However, because the short put has a higher strike price, there are also smaller potential profits if the market breaks out to the downside.

The larger premium you receive for selling a put with the same strike price compared to the amount you have to pay for the long put creates a large hedge against upside movement in the market. If prices rise, the larger premium from the short put will offset more losses than a short put in a diagonal spread would. Click here to learn more strategies for Reducing the Impact of Time Value.

Calendar Spread Case Study

In this case study, we will be looking at the following three things:

- Entering a calendar spread

- Monitoring a calendar spread

- Unwinding / Updating a calendar spread

Entering a Calendar Spread

Let’s take a look at a calendar spread on the mini-sized S&P 500 index option ($XSP). The long side of the spread, which established the trade's initial bearish bias, is made up of a long September 2009 put with a $65 strike price. The short side of the spread is made up of a short March 2009 put with a $65 strike price.

When this case study was set up in early March 2009, the long put position cost $6.60 per share, or $660 per contract, to open. The short put position brought in $1.30 per share, or $130 per contract, when it was sold. When combined with the initial long position, the total first month debit, or cost of entering the trade, is $530 per spread.

The short leg of the calendar spread is designed to reduce the amount of the spread cost attributable to time value, thereby increasing the possibilities for profits.

So why does this calendar spread have a bearish bias?

The first downside bias in this calendar spread was formed because the strike prices involved in the trade were below the initial market price. At the time, this seemed prudent to account for the downward momentum in the market. The maximum gain in a calendar spread on a monthly basis occurs if the market price equals the strike prices used at expiration. Therefore, some downside movement would have put the market price closer to that maximum gain.

The second bias was formed by the use of puts in the calendar spread. Because a calendar spread is fairly neutral, calls would offer a similar risk profile as a put spread. But at expiration, the short position would expire and you would be left with a long call, which is a bullish position. A trader with a bearish outlook would rather be left with a long put than with a long call.

Monitoring a Calendar Spread

If you offset the losses of $170 on the long put with the $130 gain on the short put, you end up with an actual loss of $40, or 7 percent ($40 / $540 = 7%) per spread. As you can see, the short spread helped to smooth volatility while the market trended against the initial forecast.

Unwinding / Updating a Calendar Spread

At expiration, there are three things that can be done to end, extend or modify the calendar strategy.

1. Unwind the trade by selling the long put

The market rallied after the case study started at the beginning of March 2009. The move was enough to create a loss in the trade. However, the losses were reduced by the premium from the short put. In that way, one of the strategic objectives of hedging your trade was achieved. At this point, if you thought the market was likely to continue to rally, exiting the position may be the best alternative.

2. Sell another short term put with a 65 strike price

In the original trade setup, the March 65 put was sold against the long September 65 put. Although the market has moved, it is still possible to sell the April 65 put to extend the trade. The extra income you would bring in from selling the April 65 put would help to reduce the basis in the trade and the maximum loss that this trade could still be exposed to in the long term. Selling another short-term put extends the strategy and resets the price at which a maximum profit is achieved to $65.

3. Leave the long put uncovered

You may decide that the market is at a potential resistance level and the long put could become profitable again as prices move back down. Leaving the put uncovered provides for virtually unlimited upside if the market falls significantly. This strategy would be superior to the second alternative of extending the spread if the market falls below the original strike price.

All three alternatives are acceptable depending on market volatility and your own tolerance for risk. Time spreads require some decision making after the short-term expiration. This allows for some flexibility and may offer cost savings over shorter-term vertical spreads as the long side of the spread does not always have to be reentered or adjusted.

John Jagerson is the author of many investing books and is a co-founder of LearningMarkets.com and ProfitingWithForex.com. His articles are regularly featured on online investing publications across the web.