What are the characteristics of this option strategy?
Reverse calendar spreads sell the longer dated option and buy the shorter dated option of the same type, strike and underlying, for a net credit. This is the mirror image of the standard calendar or time spread, which buys the long dated option and sells the short dated one, and the two should not be confused. A reverse calendar spread works against time decay. The near dated option the trader owns decays faster than the longer dated option that was sold, so the position is short theta and needs a large move in the underlying, or a rise in near term implied volatility, to pay off.
Is this a bullish, bearish or neutral strategy?
The reverse calendar spread option strategy is direction-neutral: it does not need a bullish or bearish view, only a view on how far the underlying will travel. It is not range-neutral, though. An underlying that sits still near the strike is the worst outcome, because the near dated option the trader owns decays faster than the longer dated option that was sold.
Is this a beginner or an advanced option strategy?
This is an advanced option strategy and is not suitable for novice traders. It involves complex option calculations, understanding of option “theta” or time decay, knowledge of volatility and the usage of the Greek ”Delta.” It is not a risk reducing or income producing trade: professionals use it to take a position on the shape of the volatility term structure, and they size it knowing the short longer dated leg carries open-ended risk.
In what situation will I use this strategy?
The reverse calendar spread option strategy is typically used when the trader expects a large move but has no firm view on direction, or when longer dated implied volatility looks expensive relative to near dated implied volatility and the trader expects that gap to close. Because the longer dated option is the one being sold, the setup wanted is a steep term structure where longer dated implied volatility sits well above near dated implied volatility, so the expensive option is the one going short. An underlying that stays pinned near the strike is the case this trade is not built for.
Where does this strategy typically fall in the range of risk-reward and probability of profit?
A reverse calendar spread is opened for a net credit, and that credit is the most it can make. The risk is not low. Once the long near dated option expires, the short longer dated leg is left naked, so the call version carries theoretically unlimited loss and the put version carries loss down to a zero share price. The probability of profit is typically moderate but depends on the underlying asset, market conditions, and other factors.
How is this strategy affected by the greeks?
The main effect of the greeks on this strategy is “theta” or time decay, and it runs against the position. The shorter-term option, the one the trader owns, loses value faster than the longer-term option that was sold, so every quiet day costs money. The position needs its move to arrive early rather than late. Vega is negative on the longer dated leg and positive on the near dated one, so a rise in near term implied volatility helps and a collapse in it hurts.
In what volatility regime (i.e VIX level) would this strategy be optimal?
What matters more than the outright VIX level is the shape of the term structure. The strategy is best placed when longer dated implied volatility is rich relative to near dated implied volatility, because the expensive option is the one being sold. That shape shows up after a volatility spike has been priced into the back months, or ahead of a known event that sits inside the longer expiration. In a calm market with an upward sloping term structure the credit is thin and the decay on the option the trader owns is the dominant force.
How do I adjust this strategy when the trade goes against me? And how easy or difficult is this strategy to adjust?
When the trade goes against you, the cleanest adjustment is to close the short longer dated leg, because that is the leg carrying the open-ended risk. Rolling it further out in time or further away from the money reduces the delta but extends the exposure, so it is a way of postponing the problem rather than removing it. This strategy can be difficult to adjust as the market has to offer enough liquidity in the back month to trade out at a fair price.
Where does this strategy typically fall in the range of commissions and fees?
The commission and fees for this strategy can be quite high as it involves multiple options with different expiries, leading to higher commissions and fees. In addition, traders may forgo additional fees for options adjustment, depending on the complexity of the adjustment.
Is this a good option income strategy?
No. The maximum gain is the net credit received, but the loss is not limited to any premium figure. The short leg is the longer dated one, so it outlives the option the trader owns. Once the near dated long option expires, whatever is left of the short longer dated leg is naked: the call version can lose an unlimited amount as the underlying rises, and the put version can lose down to a share price of zero. That is not an income profile, and it is not a low risk trade.
How do I know when to exit this strategy?
The hard rule is to close both legs together, before the near dated option the trader owns expires. Letting that leg go leaves a naked short longer dated option behind, which changes the risk of the position completely. Beyond that, traders exit when the spread has narrowed enough to bank most of the credit, or when the underlying has settled on the strike and the spread is widening against them. Knowing when to exit can be difficult as the market conditions may change quickly, so traders need to continuously monitor the position.
How will market makers respond to this trade being opened?
Market makers may respond to this trade by providing wider bid/ask prices in order to hedge their risk. As this strategy can be difficult to adjust and requires longer observation time, some market makers may try to avoid this strategy.
What is an example (with calculations) of this strategy?
Here’s an example of the Reverse Calendar Spread option strategy using the stock MSFT, which is trading at $285:
Assuming that we expect MSFT to make a large move within the next month, and that four month implied volatility looks expensive next to one month implied volatility, we could set up the following trade. Note the direction of each leg: the longer dated option is the one being sold.
Sell 1 MSFT call option with a strike price of $290 and an expiration date of four months for a premium of $15.00
Buy 1 MSFT call option with a strike price of $290 and an expiration date of one month for a premium of $5.00
The net credit on this trade is $10.00 per share, or $1,000 for the contract ($15.00 received on the four month call less $5.00 paid for the one month call). That $1,000 is the maximum profit, and it is only fully realised if the spread between the two options collapses to nothing, which takes a very large move away from the $290 strike in either direction.
Two things can go wrong. If MSFT sits at $290 into the one month expiration, the call we own expires worthless while the four month call we sold still carries roughly $12.00 of value, so closing the position costs $1,200 against the $1,000 credit, a loss of $200. And if we do not close it, the expiry of the long leg leaves us short a naked $290 call with three months to run, on which the loss above $290 is theoretically unlimited. The profit on a reverse calendar spread is capped at the net credit received when the position is opened; the loss is not capped.
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