Advanced Strategies for Options - Horizontal Spreads - Delta Neutral Calendar Spread

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Advanced Strategies for Options - Horizontal Spreads - Delta Neutral Calendar Spread

As you might imagine there are many ways to construct a calendar spread. Believe it or not one of the more popular types of ratio calendar spread is the Delta Neutral Calendar spread.

This type of ratio calendar spread uses the delta’s of the calls involved to construct a more accurate ratio. The spread can be created with either out-of-the money or in-the-money calls but the key is for this spread to be absolutely neutral, that is the investor should be able to earn a small profit with very minimal risk under most circumstances. This strategy is often used by professional's at large hedge funds.

For the purposes of illustration we will construct two Delta Neutral Calendar spreads using naked calls and extra long calls.

Example #1

Suppose Chase Manhattan (CMB) is trading at $50 and Dale is considering using the January 55 call and the February 55 call to establish a ratio calendar spread. Dale determines that the deltas for these calls are 0.25 and 0.15 respectively. With that information Dale decides to construct a delta neutral ratio spread. To make this spread neutral Dale divides the near month call delta by the distant month call delta (0.25/0.15) to achieve a ratio of 1.667. In other words to make the ratio spread neutral Dale is required to sell 1.667 as many of the January 55 calls as the number of February 55 calls he purchases. To make matters simple Dale sells 10 January 55 calls at $1.50 per contract and buys 6 contracts of the CMB February 55 calls at $2 per contract. The net credit for this transaction is $300.

All things being equal the probability of profit for this transaction is extremely high with very limited risk. Dale will need to monitor CMB stock to make certain the stock does not move into the money ahead of the January expiration.

Example #2

As mentioned above this strategy can be constructed with both out-of-the money and in-the-money calls. Once again with Chase Manhattan (CMB) stock trading at $50 Dale decides to construct a delta neutral ratio spread. This time Dale chooses to use the January 45 and February 45 calls. Dale determines the deltas for these options to be 0.8 and 0.7 respectively. You will note that in the case of in-the-money calls the shorter-term call has a higher delta than the longer-term call. To determine the ratio of the calendar spread Dale divides the distant month call delta by the delta of the near month call (0.7/0.8). The neutral ratio for this in-the-money spread is .875 to 1. That is Dale must sell .875 of the January call for each one of the February calls purchased. With the January 45 calls trading at $5.50, Dale sells 7 contracts for net proceeds of $3,850 and simultaneously buys 8 contracts of the February 45 call at $6 per contract for a net cost of $4,800. The net debit for this transaction is $950.

Once again this delta neutral ratio spread should yield a small profit with a high degree of probability.

At first glance it would be easy to dismiss the delta neutral strategy using in- the- money calls because this position is established for a net debit. But in-the-money calls have a distinct advantage. First there is no upside risk should the stock rise dramatically because the additional long calls would more than offset the loss for the short calls. Second if the underlying common stock remains at the same price the spread would still make money because the loss in time value for the additional long calls would be more than offset by the spread calls. The only fly in the ointment for this transaction is a precipitous drop for the underlying common stock. In this event some defensive action must be taken but even in this case the loss is limited to the initial net debit.

Summary:

1. Delta spreads are neutral.

2. The correct ratio to use in a delta spread is determined by dividing the delta of the purchased call by the delta of the written call.

3. It’s important that the ratio of the delta spread not be too large, an absolute limit such as 4 to 1 can be placed on all spread candidates.

4. The ratio should not be too small for example if the ratio is 6 to 5 it should probably be rejected.

5. If delta neutral spread is established with out-of-the money calls a net credit will occur.

6. If the delta neutral spread is established with in-the-money calls a net debit will occur.

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