Calendar spread arbitrage put options
A calendar spread consists of buying or selling a call or put of one expiration and doing the opposite in a later expiration. Many people have asked about why to use a calendar spread as directional play as opposed to a call or put spread. You can only capture time value.
Options finance Derivatives finance. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. In general, calendar spreads take advantage of horizontal volatility skews. Calendar spread arbitrage put options best case scenario is if the stock moves to that strike and then, since the event has happened, it stays still until expiration. However, once the short option expires, the remaining long position has unlimited profit potential.
At-the-money front month options decay the most as expiration approaches. Perhaps with a long call spread you are confident that you have bought the later option at a good price and that implied volatility will go up. Calendar spread arbitrage put options the same time, you will sell the back-month put to close your position. If stock moves too far and the strike is either way in-the-money or way out-of-the-money the time value of the spread will go to zero as the options will be worth the same amount, either parity or zero.
However, when selecting the short strike, it is a good practice to always sell the shortest dated option available. This is a nice strategy in sketchy market conditions where everything has been jittery. In summary, it is important to remember that a long calendar spread is a neutral - and in some instances a directional - trading strategy that is used when a trader calendar spread arbitrage put options a gradual or sideways movement in the short term and has more direction bias over the life of the longer-dated option.
The gamma of the front month option protects you from near term movement and yet the short vega of the longer term option allows you to sell high premium while allowing time for it to come in. You might want to hold on to it or even calendar spread arbitrage put options it as the first leg of a call or put spread. You want stock to move, but implied volatility to come in. For this strategy, time decay is your friend.