Calendar Spreads Options: An In-Depth Guide
What are Calendar Spreads?
A calendar spread is a neutral strategy that profits from time decay and an increase in implied volatility.
A calendar spread can be constructed with either calls or puts by simultaneously entering a long and short position on the same underlying asset but with different expiry dates. Since the goal is to profit from time decay and volatility, the strike price should be as near to the underlying asset’s price as possible. This strategy takes advantage of how near and far dated options act when there is a change in time and volatility.
When running this strategy, you are taking advantage of accelerating time decay on the front-month (short term) option as expiry approaches. Just before the front-month expiration, you are looking to buy back the shorter-term option for near-zero cost but at the same time, you will sell the back-month call to close your position. Ideally, the back-month call will still have significant time value in its price.
Components of an Options Calendar Spread
The Short Option
The short option component of a calendar spread is a short-term option sold to other traders. This option brings immediate premium income into your account, but it obligates you to sell or buy the underlying security if it is exercised.
The Long Option
Conversely, the long option in the calendar spread acts as an insurance policy. It is purchased to cover the potential obligation from the short option. If the short option is exercised, you can fulfil your obligation using the long option, which has the same strike price but a longer expiration period.
Long vs. Short Calendar Spreads
There are two types of calendar spreads based on the trader’s position—Long and Short.
Long Calendar Spread
In a long calendar spread, a trader buys a longer-term option and sells a shorter-term option. The idea is to profit from the rapid time decay of the near-term option sold, which ideally results in a net credit when exiting the trade.
Short Calendar Spread
On the contrary, a short calendar spread involves selling a longer-term option and buying a shorter-term option. The goal is to benefit from an increase in the options’ implied volatility or a sharp move in the underlying asset’s price.
Execution and Management of Calendar Spreads
Once you’ve selected the underlying asset and the appropriate strike and expiration dates, it’s time to execute your options calendar spread. You’ll sell the short-term option and buy the long-term option simultaneously, setting up the spread.
However, once the spread is established, it’s crucial to actively manage your position. Keep a close eye on the underlying asset’s price, the short option’s time decay, and changes in implied volatility.
If the short option becomes too risky – if the stock’s price moves too close to the strike price – you might need to close your position early or adjust it. You could roll the short option to a further expiration date or a different strike price, or you might choose to close the spread entirely.
Exiting the Trade: What Are Your Options?
When it comes to exiting your calendar spread, you have several options:
Let the short option expire worthless: If the underlying asset’s price is below the strike price at expiration, the short option will expire worthless. You can then sell another short option against the long option, creating a new calendar spread.
Close the spread: If the stock’s price moves too far from the strike price or implied volatility changes, you can close the spread to prevent further losses.
Roll the short option: If the stock’s price moves close to the strike price, you can roll the short option to a later expiration date, extending the trade’s life.
Exiting the Trade: What Are Your Options?
Like any trading strategy, calendar spreads have their strengths and weaknesses.
Reduced Risk: Calendar spreads limit downside risk to the initial investment, providing a safety net for traders.
Flexibility: These spreads are flexible, allowing adjustments based on market conditions.
Profit Potential: Traders can profit from time decay and volatility changes, widening the range of profitability.
Limited Profit: The potential profit is limited to the premium received from the short-term option.
Market Sensitivity: Calendar spreads are susceptible to changes in implied volatility and the underlying asset’s price.
Execution Risk: Mispricing or changes in spread can affect the trade execution.
Early Assignments: The biggest risk on your short option call/put is an early assignment, if the stock moves quickly against you this could be exercised, leaving you with high costs, stamp duty and commission fees.
Selecting the Right Strike Price
Choosing the right strike price is paramount in a calendar spread. If the trader believes the underlying asset’s price will rise, they may choose a strike price slightly above the current price. Conversely, if they predict a price drop, a strike price slightly below the current price may be chosen.
Timing the Trade
Timing is also crucial in the execution of calendar spreads. Traders usually establish long calendar spreads when they anticipate an increase in implied volatility and establish short calendar spreads when they expect a decrease.
Calendar Spread Example
A trader believes that the market will be quiet and move sideways until after the December expiration, after which they believe that the market may rally again.
The easiest options to trade here would be to simply buy a March call benefiting from the expected move. However, the March call premium will undoubtedly be expensive due to the amount of time left in the option.
The other way to handle this is to offset some of the call premium by selling a shorter-term call. This is referred to as buying the calendar spread.
The best-case scenario for this trade would be for the market to remain stable until after the December expiry.
Calendar Spread Summary
Calendar spreads provide a potent, flexible, yet intricate trading strategy. Understanding these spreads is essential for any trader seeking to expand their repertoire and venture beyond basic trading methodologies. By balancing the risk and potential reward, selecting the right strike price, and timing the trade, one can navigate the financial markets with precision and expertise.
By understanding the fundamental principles of options calendar spreads, traders can take advantage of time decay and volatility to potentially enhance their portfolio returns. Remember, it’s essential to consider your individual risk tolerance and investment goals when utilising this or any other options strategy.
- Sell a put/call with a strike price near to expiry (Front-month).
- Buy a put/call with the same strike price as above but one month later (back month).
- Both legs need to be either calls or puts.
- Low activity – You are looking for minimal movement in the underlying asset.
- The underlying asset price is to be as close to your strike as possible when the front-month expires.
Max Potential Profit:
- Potential profit is limited to the premium received for the back-month option minus the cost to buy back the front-month option, minus the net debit paid to establish the position.
Max Potential Loss:
- Limited to the premium paid when the trade was opened plus any fees.
What is an options calendar spread?
An options calendar spread, also known as a time spread or a horizontal spread, is a strategy that involves selling a short-term option and buying a longer-term option with the same strike price. Traders use this strategy to capitalise on time decay and changes in implied volatility.
How can an options calendar spread benefit traders?
The main benefits of an options calendar spread include the ability to generate income from time decay of the short-term option and the potential to profit from changes in implied volatility. If the underlying stock’s price remains near the strike price until the near-term option’s expiration, the trader can profit.
What are the key components of an options calendar spread?
The key components of a calendar spread are the short option, which is sold, and the long option, which is purchased. Both options have the same strike price, but different expiration dates.
How is the strike price selected in an options calendar spread?
The strike price in a calendar spread should reflect where you anticipate the underlying asset will trade by the expiration date of the short option. A strike price at-the-money (ATM) typically offers the highest potential return if the stock remains stagnant.
What are the potential risks involved in options calendar spread trading?
The risks in a calendar spread include significant price movements of the underlying stock and changes in implied volatility. A sharp move in the stock price could cause the short option to go in-the-money, potentially resulting in losses
How can a trader exit an options calendar spread?
Traders can exit a calendar spread in several ways: let the short option expire worthless and create a new calendar spread with the long option, close the spread to prevent further losses, or roll the short option to a different strike price or a later expiration date.