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.
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
- 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.