Before derivatives settlements, option traders examine calendar spreads. These try to exploit expiry effects. A typical calendar spread is a short close to money (CTM) call (short put) in the near series, coupled with a long call (long put) in the next time series.
If the short expires without being struck, the premium inflow reduces cost of the “live” long position. If the short is struck and loses, the premium on the long position also rises and compensates.
Take a typical trade with a bearish view. The Nifty closed at 5,469 on Tuesday. The CTM February 5,400 put last traded at Rs 15 premium. The March 5,400p last traded at Rs 128. A short February put, plus a long March put, leads to net cost of 113. This is a basic calendar spread.
A delta-hedger will tweak to take a “ratio spread”. Delta is the amount premium changes for every one unit change in underlying. As a rule of thumb, near-term delta in-the-money (ITM) options have ratios higher than 0.5 – may be as high as 0.9 deep in the money. On-the-money (OTM) delta is 0.5.
A CTM near-term put, like the Feb 5,400p has a delta of minus 0.25. The premium moves Rs 25 for a 100-point shift in Nifty, rising when Nifty falls. The March CTM 5,400p has a delta of minus 0.15. The calendar delta ratio is 1.7 to 1.
A delta trader will sell 16 lots, that is 800 February 5,400p and buys 10 lots (500) March 5,400p. The net is Rs 52,000. If the short expires without Nifty falling below 5,400, he holds 500 long March 5,400p at an average cost of Rs 104, as opposed to Rs 113 with a 1:1 ratio.
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Say, the Nifty drops to 5,350 today. If delta holds, the February 5,400p premium rises to 27.5. This is a loss of (12.5x800) Rs 10,000. But the March 5400p also rises 7.5 to 136, reducing net loss to Rs 6,350, if both positions are reversed. If short February puts are settled and long March puts held, the Long March puts cost an average 141, as opposed to about 133/ put with 1:1 ratio.
If settlement is at 5,350, the short February 5,400p position loses Rs 28,000 (Rs 35/ put). But the March 5,400p is now near-term ITM with a delta of minus 0.6. The March 5,400p premium jumps to 158 – an unrealised gain of 30/ put. After settling February puts, the trader holds 500 long March 5,400p. His net unrealised loss is Rs 13,000 (Rs 26/ put) on the total outlay. He breaks even if the underlying Nifty drops another 40-50 points to about 5,300 (assuming delta stays at minus 0.6).
The 1.6 delta ratio calendar spread can lose more than the vanilla 1:1 calendar spread. But, it can also gain more. Even in the losing positions, it leaves good chances of decent future returns. Premiums change very rapidly around settlement, so, continuous recalculation and monitoring is required for this sort of trade. Trader should also look slightly further from money where risks of being struck are less, etc. Learning how to work delta calendar spreads is definitely a useful technique in the tool kit.
The author is a technical and equity analyst