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Diagonal Calendar Spread Example Help Guide

Click PDF to get a PDF printable version of this help file.

A diagonal calendar spread is composed of two options of the same type (both calls or both
puts) with different exercise prices, different expiration months and opposing positions. Calendar
spreads are also called time spreads.

This example will show how to use the Platinum 3.0 tools to find and analyze a Buy Put diagonal
calendar spread. We will be buying an OTM put that has a far month expiration and selling an
ATM put that has a short month expiration. As time passes the short-month put will loose value
faster than the long-term put. If the underlying stock stays above the near month option strike
prices, the short put will loose all value. The long put will still have time value left to go. If the
near month put expires with the stock near the option strike price, we will get to keep the near
month put credit and sell the far month put, capturing its remaining time value.

One objective in buying the calendar spread is to have the short, near month option have higher
implied volatility than the long, far month option. This means we receive a substantial credit to
sell the near month put (we want near month implied volatility to be high ) and do not have to
pay extra to buy the far month put ( far month implied volatility is lower). The net cost to buy
the calendar spread will be low.

It is interesting to see what happens in diagonal calendar spreads as the stock moves away from
the ATM strike price. The calendar spread difference between the two options begins to collapse.
As the stock increases in price, both puts loose value until the profit becomes:

Profit = (Sell Price - Buy Price)

The Sell Price must be higher than the Buy Price. Even if assigned we profit. On the downside:

Profit = (Buy Strike - Sell Strike) + (Sell Price - Buy Price)

BUT we have one adjustment at our disposal. As the stock decreases, we can close the short
option and sell another short option closer to the far strike and possibly at a later time to also
capture premium. The adjustment also lowers your possibility of assignment.

A diagonal calendar spread can also increase in value if implied volatility increases. If implied
volatility increases, both options increase in value, but the far month put will gain more value.
The profit region will grow. The stock will often move away from the strike price that would
normally cause the ATM long calendar spread to loose money. This movement can also cause
implied volatility to increase. The calendar spread may not only hold value, but it can even
increase in value as future uncertainty grows.

As mentioned a diagonal calendar spread can also be rolled over. That is if the original short put
and long put are separated by at least two expiration time periods, then when the short put
comes close to expiration, buy it back to close the position and capture profits then sell the next
put in time closer to the long put and start a new calendar spread with the previous long put
position.

These are then are the characteristics we are looking for in a long ATM calendar spread.
 1. High near month implied volatility and lower far month implied volatility such that upside
stock movement is profitable. (Low cost to buy the spread)
2. A stock with a recent trading range around the chosen strikes and even trending up or an
overall bullish outlook.
3. A stock with a lower price that may be consolidating. (Avoid major movement on the
down side)

Creating A List of Favorable Stocks

Logging into the Platinum 3.0 web site brings you to one of two start pages. We are going to use
Site Map as the start page.

You can form stock lists and search for trades using the latest option data for the latest end-of-
day date. Or you can change the date to a trading date in the past 1.5 years. We recommend
you follow along using the date used. To change the web site date, read Update Web Site Date.
We are using the date: 03-10-03.

SkewFinder is a tool to narrow our search for calendar spreads to a list of stocks that have
desired characteristics. The purpose of the ranker is to create a stock list that we can input into
another Platinum tool: Find Trades III or Strategy Maker. We do this, because Find Trades III
and Strategy Maker are limited to 4000 trade searches. Only a few stocks (500 or less) in the
Find Trades III input list can max out the trade search limit.

Perform these steps

z Click SkewFinder on Site Map below Stock Lists

z On the right side is: Skew Search Wizard Settings. Select the ATM Put Diagonal Bullish
Calendar Wizard
z Click the Ranking button. Click the CONTINUE button if SkewFinder does not finish in the
time allotted. You are sharing resources with fellow Platinum users.
z Next to replace at the top, enter 100 in the text box shown.
z Select an unused list and in the list name text box, backspace out the old name and type
in High "Diag Put Skew 3-10-03".
z Click the REPLACE button.

The image should appear as shown below. NOTE: stocks get deleted as companies get bought
out so you may not get all the stocks shown in the list. For example,
At the top navigation links click, Settings > Search Settings. This allows you to pick the columns
in the search output, make My View the default view and change the Odds displayed. We are
going to allow maximum Odds. Make the selections shown in this image:
 z At the top click Search tools > Find Trades III
z Choose high diag put skew 3/10/03 as the input stock list on the Find Trades III web
page. The page will automatically reload with that list of stocks shown.
z Above the stock list, name the search "III Diag Put Cal Spd" in the text box shown next to
"name".
z Checkbox "High IV Put Diag Calendar" in the left column of the strategy matrix.

We have four Put Diagonals we can search. There are three ways to make money with stock
movement: Up, Down, Sideways. The Put Diagonal allows you to pick Sideways plus Up or
Down. The decision is based on whether you are bullish or bearish. If you choose wrong it is
likely you will loose money but your losses are limited. We are bullish on 3/10/03.

We have chosen Puts because if you try this with Calls, the possible profits are too small. In a
previously down market, Put IV tends to be high with good skew. Calls can become Calendar
favorable in a bullish market.

The strategy we can use is in the left top side of the Strategy Matrix.
We now make these choices which are also good for any Buy Calendar search.

z The initial sorter is Maximum Profit/(-Risk). It is the first sorter and you may have to slide
the slider up to see it/
z Statistical Volatility Computed Using: 100 day SV. This is used by the Kelly Bet Fraction.
100 days gives a good SV estimate.
z Implied Volatility history uses: 1 year. This is used by the Skew Filter
z Primary Leg Strike Search from Stock Close Price: Both. If you choose Both and 0 in the
direction (next) you get the best up or down ATM strike. If you choose Up only you only
get the best UP only ATM strike.
z Primary Strike UP Search: 0 We want ATM strikes only.
z Primary Strike DOWN Search: 0
z Minimum Strike Increment (Secondary and Primary): 2.5. We want to try half strikes.
z Maximum Primary to Secondary Strike Width: 5.0 We only want this much separation of
strikes.
In the option world of filling legs, volume can be very low but we need some Open Interest, real
quotes and good quotes

z Volume must be greater than or equal: 0

z Open Interest must be greater than or equal: 10
z Real Quotes: yes
z Reject Option: yes using $400

We get to decide the minimum days to the near expiration month, the maximum days to
the far expiration month and the minimum and maximum days between calendar legs.
We want the skew filter on at 5%. Our choices are:
At the bottom of the search page are IV filters. The only one applicable to Calendar Spreads is
the Buy side Sell side IV filter. The near month far month filters are actually only looking at the
ATM IV of the option chain, not the individual leg IVs. You could turn on the Buy Side /Sell Side
filter and set the % to say 5% or 10%. This limits the search output to trades with legs with
those characteristics.

Click the SAVE button. Click at the top Search Tools > Saved Searches. Look for your saved
search, select the trade list we created ( it should already be selected), and click the List link
next to it. You will get a timer page. (NOTE: if the search ends before the timer reaches its limit,
your ISP has timed out the browser searcher connection. This happens sometimes to non-USA
users. Go to General Settings and lower the search time allowed.)

On 03-10-2003 we got
"The top ranked 23 trades out of 586 searched."
We are going to resort the trades. Click "Buy IV Sell IV" to resort by IV Skew. Here is what it
looks like:

The Ford F trade has low risk. High reward of 10:1 and high IV skew. Note that we are basically
short put sellers (unlike short call sellers there is a limited loss to naked short puts in that the
stock cannot go below 0.0) but we are not naked and protect the possible downside condition
with the low cost buy put. The possibility of assignment is also high so your account needs
margin.

z Buy 1 APR03 7.5 Put@ 0.90

z Sell 1 JUN03 12.5 Put@ 5.60
We will now show Calendar Rolling.

Right mouse click that trade and select open in a new window. Pick a Folder, name the trade
next to "Current Trade" and click the SAVE button. At the top right, change the web site date to
4/16/2003 and click GO. The stock moved up into the profit zone. We are going to close the
April Put and Open a May Put. After using Edit Trade, we get this display in the Risk Graph.
We are using Chart autoscale Off and 50% x-axis settings. The trade is basically a long synthetic
vertical call spread.

The four lines plotted in the Risk Graph are the potential profit and losses of the option trade as
the stock price varies. Each line is for a different time in the future. The graph is only valid up to
the expiration of the near month option trade. The black line shows the final possible outcomes
of the option trade as the stock price is varied between 20 and 8 at the near month expiration
date. Losses are finite. The Ford trade was done in the past. We can see a historical view of the
trades profits and losses to today's prices. Click Trade Tools > Backtest Trade w/IV model or
w/Greeks to use that function.

By 5/16/03, Ford rose some more and then went sideways. We captured more premium out of
the short put and exited the trade taking a profit of $205.

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