Calendar Spread 

Among the many options trading strategies offered, some are of interest to specific market conditions and trader goals. One such strategy is the calendar spread, more commonly referred to by its nicknames, the time or horizontal spread. This strategy is extensively valued for its capacity to exploit time decay and volatility shifts. This article examines the basics of calendar spreads and provides an in-depth yet clear explanation that is ideal for beginners. 

What is a Calendar Spread? 

A calendar spread refers to an options strategy that has the simultaneous purchase and sale of two options contracts: 

• Underlying Asset: The two options share the same underlying asset (such as a stock or index). 

• Strike Price: The options also have the same strike price. 

• Expiration Dates: The options do not have the sme expiration date. 

Generally, an option trader will sell a near-term option (one with a closer expiration) and purchase a long-term option (one with a distant expiration). The main goal is to take advantage of the rates at which these options lose value as time passes, an idea referred to as time decay. 

Understanding Calendar Spread 

It’s critical to understand two things: time decay and implied volatility, in order to comprehend how calendar spreads work. 

Time Decay (Theta) 

Options are time-sensitive financial instruments. As the expiration date nears, the option’s extrinsic value decreases, a process known as time decay. Notably, short-term options suffer from time decay faster than long-term options. By selling a short-term option and purchasing a long-term option, traders seek to gain from this quicker decay in the value of the short-term option. 

Implied Volatility (Vega) 

Implied volatility measures the market’s prediction of a security’s future price movements. Rising implied volatility tends to increase option premiums, whereas falling implied volatility decreases them. Calendar spreads are favourable when implied volatility increases because the long-term option (owned by the trader) is more volatility-sensitive than the short-term option (sold by the trader). 

Fundamentals of Calendar Spreads 

Types of Calendar Spreads 

1. Long Call Calendar Spread: This strategy involves purchasing a long-dated call option and selling a short-dated call option with the same strike. It is used mostly when a trader expects limited price movement of the underlying asset.
2. Long Put Calendar Spread: This strategy involves purchasing a long-term put option and selling a short-term put option with the same strike price. It is employed when a trader anticipates the price of the underlying asset staying flat or decreasing slightly.
3. Reverse Calendar Spread: Selling a long option and buying a short option. Traders may employ this strategy when anticipating a significant price movement in the underlying asset or a drop in implied volatility.

Profit Mechanism & Market Conditions 

A calendar spread gains when the underlying asset’s price remains close to the strike price when the short-term option expires. The trader keeps the premium if it expires worthless, and the long-term option still has value. It is most effective in stable markets with low volatility since it gains from time decay and implied volatility shifts. Directionally neutral, it does not rely on substantial price action but on time-related factors for profitability. 

Risk Management in Calendar Spread  

Although calendar spreads generally involve limited risk, effective risk management is necessary to counter any possible losses. 

Critical Risks 

• Price Movement Risk: As the underlying instrument’s price shifts far away from the strike price, the short-term and long-term options will lose value and result in losses. 

• Volatility Risk: Decreases in implied volatility can decrease the value of the long option more than the short option, harming the position. 

• Liquidity Risk: Thin options markets may result in wider bid-ask spreads, making it difficult to open or close positions at favourable prices. 

Risk Management Methods 

Proper risk management is crucial for minimising possible losses in calendar spreads. 

• Position Sizing: Invest capital sensibly so that no one trade affects your portfolio significantly. 

• Stop-Loss Orders: Establish predetermined exit points to contain losses when the asset’s price goes against you. 

• Regular Monitoring: Monitor market conditions since surprises can influence the performance of a trade. 

• Diversification: Investment in other assets or strategies for reducing risk exposure. 

• Position Adjusting: Refine positions by rolling spreads to different strike prices or expiry dates as market conditions change. 

By employing these tactics, traders can better control risks and maximise their calendar spread positions. 

Examples of Calendar Spreads 

To better understand how calendar spreads work in practice, let’s look at two examples involving famous companies. 

Example 1: Long Call Calendar Spread 

Assume Apple Inc. (AAPL) is quoted at US$150 per share: 

• Buy one call with a US$150 strike price that expires in 90 days for a US$5 premium. 

• Sell a call with a US$150 strike price that expires in 30 days for a US$2 premium. 

• The net cost (maximum possible loss) is US$3 per share (US$5 – US$2). If AAPL’s stock price remains near US$150 after 30 days, the sold call expires worthless, and the bought call has value. 

Example 2: Long Put Calendar Spread 

Suppose Tesla Inc. (TSLA) is trading at $700 per share: 

• Buy one put with a 60-day expiration and a strike price of US$680 for a US$10 premium. 

• Sell one put with a 30-day expiration and a strike price of US$680 for a US$6 premium. 

• Net cost is US$4 per share (US$10 – US$6). If the stock price of TSLA falls somewhat but is still around US$680 after 30 days, the expired put is worthless, leaving profit potential on the bought put. 

Example 3: Futures Calendar Spread 

In futures markets, one may sell spreads such as: 

• Sell September S&P 500 futures contract. 

• Buy December S&P 500 futures contract. 

• This spread gains if the spread between December and September futures prices decreases with time. 

Frequently Asked Questions