One of my favorite and most profitable strategies is buying a directional Diagonal spread for a debit and then rolling that Diagonal into a Calendar spread when the opportunity to get to zero cost arises. Simple! No? Ok, let me translate that for you! It means when I can sell the Vertical spread that ‘converts’ the Diagonal into a Calendar for a credit in the same amount of the debit originally paid to buy the Diagonal. No? The translation didn’t help? 😣 Better to look at an example to clear everything up! Below is a tweet explaining that I had just done a Diagonal ‘rolldown’. Below the tweet are the trade fills to get to a net zero cost Calendar spread.
Step 1: buy a Diagonal spread. Step 2: IF price moves in the expected direction THEN sell a Vertical spread for a Credit in same amount as the Debit paid for the purchase of the Diagonal spread. It took exactly 41 minutes and 4 seconds and a SPX price drop of about 20 points to get to net zero cost on a Calendar spread!
Hopefully that cleared things up about how I get into zero cost Calendars. Once that’s done I don’t ever have to worry about managing the position, right? Not right! The title of the post, Deep ITM (In-The-Money) Calendar Spreads, describes a situation that I often find myself in where SPX moves far past the strike price of the Calendar towards the ITM side. If there’s still plenty of time before the Calendar’s expiration that’s not really a problem but if it’s within a day or two of expiration, it’s getting to be a problem. And if it’s within a few hours of expiration it’s a BIG problem! One that will undoubtedly prompt a call from your broker saying if you don’t close it SOON, they will! Why the panic and what’s the big deal? Before I get to that lets take a look at the SPX option chain to get an idea of what we’re looking at.
Below is the SPX option chain with 1 DTE (Days-To-Expiration). SPX was at 3758 so if I owned both 3900 and 3800 Put Calendars they would both be ITM. The 3900 Calendar would be considered quite deep ITM. The 3800 Puts with 1 DTE show a bid/ask spread of $2.50 which is pretty wide compared to the $.50 or so wide spreads that are more typical for SPX options. The 3900 Puts have a $4.20 wide spread. That’s a concern when you are trying to close out those short Puts because you’ll experience a greater amount of slippage on the trade. Google ‘trade slippage’ if you don’t know what that means. Trust me, it’s not good!
Ok, now fast forward to the next day, expiration day. SPX dropped from 3758 down to 3693 pushing the 3900 and 3800 Put Calendars much further ITM! The bid/ask spread is $7.70 on the 3800 Puts and $16.00 on the 3900 Puts. If you’re are trying to exit those Puts you could experience a huge amount of slippage on that trade execution!
Below are the actual fills I was able to get on expiration morning of the 3800 Put Calendars while the strike price was about $75 ITM. Pretty good size credits for deep ITM Calendars but notice the time of the fills. Between 15 and 30 minutes after the open! When Calendars are deep ITM get the orders filled early, don’t wait!
So waiting until late in the day on expiration day isn’t a good idea but why exit the trade at all? SPX options settle to cash at their intrinsic value so why not just let the options settle? If this was a deep ITM Vertical spread that would be a fine solution since both the long and short options expire at the same time. This isn’t a Vertical spread! It’s a time spread where the long option expires after the short option. BIG DIFFERENCE! I’ll use an example to explain why. In the option chain I showed previously, if I didn’t exit the 3800 Calendar by the close of the short Puts expiration then the short Puts settle to cash at an intrinsic value of 106.77 (3800 strike minus SPX closing price of 3693.23). That’s a minus 106.77 which means the broker subtracts $10,677 from my account for each contract that I held. So what? I own the 3800 Puts that don’t expire until 3 days later (in this particular Calendar it was a Fri/Mon expiry). Those are worth more than 106.77 so I’m covered, right? Well, those Puts were worth more than 106.77 at Friday’s close but, since I didn’t close the long Puts before Friday’s expiry, I don’t know what they’ll be worth on Monday when I can sell them. Lets say there’s some news over the weekend and SPX gaps up by say 100 points on Monday and then continues to rally higher above 3800. Now what are those 3800 Puts worth? $30? $20? $10? Whatever price it is it will be substantially less than the 106.77 that the broker subtracted from your account at Friday’s expiry. You could theoretically lose the entire 106.77 for each contract you owned! Now you can see why you must either exit a time spread or roll it into a Vertical spread before the short option expires. Those are the 2 choices. You cannot just let the short option expire in a ITM Calendar spread!
For most traders that’ll be all they need to read of this post. If you’re interested in a few twists in regards to Calendar spreads then keep reading!
One of the techniques that I use in trying to stay out of an ITM Calendar is the Calendar flip. If the analysis of a price chart leads me to have a directional bias that would cause the Calendar spread that I own to potentially go deep ITM I’ll close that Calendar and, in the same transaction, flip it from Puts to Calls or from Calls to Puts, depending on the situation. Below I did just that by closing out a Put Calendar and flipping it to a Call Calendar for a Credit. It usually only can be done for a credit if SPX is still relatively close to the strike price and there’s plenty of time left before expiry. However, even if it is done for a small debit, say $.20 or less, then it might save you from the situation that I described earlier in this post.
Another potential solution is the Double Calendar comprised of both a Put and Call Calendar. It’s impossible in the Double Calendar below for both Calendars to be ITM at expiration.
What if I thought price was going lower and I wanted a directional Double Calendar but also wanted to avoid the possibility of eventually having 2 deep ITM Put Calendars? I could initiate the position by buying an Call and Put Double Calendar even though the Call Calendar was ITM when the trade was initiated. See the risk profile below.
Finally, I want to address the issue of the time value of a Calendar spread. See the risk profile below. I’m showing 3 different expiration cycles. Notice the difference in the price of the Calendars. The further out in time the cheaper it is to buy the same strike Calendar if the expiry cycle (Fri/Mon) is the same. That risk profile can also show you how much a Calendar spread will gain in value if SPX and VIX remain constant. A Calendar spread that’s bought for $2.75 with 3 weeks to expiry will be worth $3.65 a week later and $5.05 two weeks later.
11/6/2022 Update: In order to answer a question posed about this post after I had finished it, I’m adding the 2 risk profiles below. The question was “are you aiming to take off a calendar when price is at the peak of the tent”? The answer is a definitive NO! I don’t trade options in the traditional sense of trading. Most traders enter a position and then, at some point prior to expiration, exit the position. I don’t do that. I initiate a directional trade with a specific stop based on a chart setup. If price moves against my position then I’m stopped out with a relatively small loss. If the price moves in favor of my position I typically DH (Delta Hedge) it into a net zero cost position. That means I have removed all of the initial cost. Then I move onto a new trade. I don’t exit the first position when I’m adding a new position. That new position is either stopped out or taken to a net zero cost. Then it’s onto another new trade and I repeat the process over and over and over again. That is how I build extremely wide profit risk profiles as shown below. The width of the profitable area is over 500 SPX points with 1 week to expiry!
Below is a closer-up look at the same risk profile. Clearly I have a bearish bias for the coming week based on the potential profit tent. Does that mean that I have a large amount of Delta (directional) risk? Definitely not! The position is short (negative) 20 SPX Deltas. That’s considered to be relative neutral for directional risk.
My trading strategy is wrapped completely around building wide positions that have little to no net cost.
That’s everything I wanted to cover in the post. Got a question or comment? Leave it down below!
That is great, thanks so much. In the last example, wouldn’t it be beneficial to enter the Friday/ Monday calendar about 3 weeks out to get a safer, cheaper trade and be able to bank that theta, albeit slower moving than the final week? Would it be easier to roll your diagonals to calendars 3 weeks out than with one week to go?
Mark, I believe the ‘safest’ way to trade options is to have a portfolio that consists of short options in multiple strikes spread out over multiple expirations. Time risk is a very real thing for options traders! In fact, you’ll find a post on the blog titled ‘Time Risk’. Read it when you have a chance. If you choose to mostly initiate trades with around 3 weeks to expiry to get a lower entry price that’s absolutely fine! As time passes you’ll gain Theta from your existing positions while continuing to initiate new trades with 3 weeks to expiry. This past week I initiated a *Dec30* OTM Call Condor by first buying Calls to hedge my 3-day Put Calendars (see my tweet from Friday, 10/28 describing the position). So I was hedging 7-14 DTE Put Calendars with Dec30 Calls. That because I wanted to start building a position for a potential ‘Santa Claus’ rally. There are so many ways to hedge an options portfolio! Hope this answered you question. If not, let me know.
thanks for this outstanding post. It brings up a few questions. here’s the first, probably obvious but want to be sure. Best outcome would be if the short option is OTM the day it expires. Say SPX settles at 3810. Then would it be wise to keep the long option in case on Monday it went back down ITM and the long put was worth quite a bit? What if you close some on Friday and keep some for Monday in case?
In your example, since you know that the short Put is expiring worthless you could hold onto the long Put with no risk of being ‘underwater’ however that Monday Put would be worth a considerable amount, likely in the $10-$15 range (maybe more depending on IV). Are you willing to risk having those Puts being worth maybe $2-$3 (or less) on Monday morning if SPX gaps up on Monday’s open? I don’t take that kind of un-hedged risk personally but to each his own. If you owned more than 1 Put you could sell-to-close some and keep the rest OR you can buy back the short Put that’s expiring in a few minutes for probably $.25-$.50 or so and sell a further OTM Put *expiring on Monday* for a decent amount. That way you’d own Put Vertical spreads that expire on Monday’s close. On this past Friday’s close, the Monday Puts that were $10 OTM were worth $13.50, $20 OTM Puts were $10.50 and $30 OTM Puts were $8.00. That way you could profit from a continued move lower while dramatically reducing your risk should SPX move up instead.
A couple of more questions– first, in general are you aiming to take off a calendar when price is at the peak of the tent– how long in general do you hold them? it seemed that rolling the calendar to get closer to a “pin” is not that expensive when i experimented with one in SPY—only a few cents. I guess it depends if it stays relatively close to the money.
second, given that as you explain, the time value increases and calendars are cheaper further out in time—that is not true for RS+ though, right?
In order to answer your first question I’ve added a 11/6/2022 update to the post. As to your second question, there are 2 components in a RS+ position; there’s a vertical and a horizontal (time) spread embedded in the position. The time spread component of the RS+ is generally cheaper the further out in time.