Last update: July 2021

I’ve had calendars on my mind of late. I introduced them to you two weeks ago here. Last night I featured them in the latest Mind of a Trader webinar (PRO Members Only). Catch the recording if you missed it.

Today I wanted to continue the investigation with a focus on delta differential. If you’re going to use calendars, it is imperative that you understand this principle. Otherwise, your positions won’t behave as anticipated and you’ll get frustrated.

There are two ways to view calendar spreads.

The first is as a substitute for covered calls. Perhaps you’ve heard of the Poor Man’s Covered Call. Well, it’s a calendar spread. The objective is to create a position that behaves like a covered call but is much cheaper to deploy.

The second method for using calendars is as a simple cash flow trade that can be skewed bullish, neutral, or bearish, depending on your outlook.

It’s the first approach that I find traders often mess up because of misunderstanding the role that delta plays in the trade. Delta differential is simply the difference between the delta of the option you purchase and the option you sell. For example, if I buy a +60 delta call and sell a -40 delta call, then my delta is +20.

Here are a few vital details that come into play with calendars.

1. One: the delta of short-term options rises to 100 faster than long-term options.
2. Two: if the delta differential isn’t large enough when you build your trade then a bullish calendar spread can turn bearish.
3. Three: This means if the stock rises too far you will lose money. It’s an outcome that would never happen if you had a covered call.

Think about the delta of a covered call for a moment. You buy 100 shares of stock and acquire a +100 delta. Then you sell an OTM call with a delta of -35.

• Long Stock +100 Delta
• Short Call -35 Delta
• Delta Differential: +65

Since the short call delta will never move above -100, the overall position delta will never drop below zero. If your call ran deep ITM this is what the position would look like:

• Long Stock +100 Delta
• Short Call -100 Delta
• Delta Differential: 0

When this happens, it means you’ve captured the max profit in the covered call. You won’t make any more money if the stock continues to rise, but you won’t give back gains either.

Suppose instead of the covered call you decide to deploy a calendar spread as a substitute. Maybe it looks like this:

• Long 3-month ITM call: +57 delta
• Short 1-month OTM call: -33 delta
• Delta Differential: +24

Notice how the delta differential on the covered call was much larger than this calendar (+65 vs. +24). Here’s the problem with the spread as structured. Because the delta differential was too small at the outset, the overall delta will turn negative if the stock rises too far. That means your trade (which you intended to start bullish and stay bullish) will eventually turn bearish.

There’s nothing more frustrating than placing what you thought was a bullish trade and then end up losing money because the stock rallied too far. Here is the risk graph of the poorly structured calendar:

The white box shows you have an upper breakeven. The risk graph slips into the loss zone if the stock rallies too much.

Here is the solution and the main point of today’s piece.

If you’re trying to use the calendar as a covered call substitute, then make sure the delta differential is large enough that your risk graph doesn’t drop below zero if the stock rises too far.

This can be accomplished by either:

1. Buying a deeper ITM call,
2. Selling a farther OTM call, or
3. Doing both.

Here’s a better-structured calendar.

• Long 3-month deeper ITM call: +80 delta
• Short 1-month OTM call: -33 delta
• Delta Differential: +47

Notice the difference in this risk graph versus the prior one.

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