A Calendar Spread, also known as a time spread or horizontal spread, is an options trading strategy that involves simultaneously buying and selling options of the same underlying asset with the same strike price but different expiration dates. This strategy is designed to profit from changes in implied volatility, time decay (theta), and price movement of the underlying asset.

Understanding a Calendar Spread

In a calendar spread:

• Long Option: You buy an option with a longer expiration date.
• Short Option: You sell an option with a shorter expiration date.

Both options have the same strike price, but their difference in expiration dates creates opportunities to profit from the interplay of time decay and volatility.

Types of Calendar Spreads

1. Call Calendar Spread:
   • Involves buying and selling call options.
   • Profits if the underlying asset remains near the strike price by the short option’s expiration.
2. Put Calendar Spread:
   • Involves buying and selling put options.
   • Functions similarly to the call calendar spread but is used for bearish or neutral market expectations.

How a Calendar Spread Works

• Time Decay (Theta): The short option decays faster than the long option because its expiration date is closer. This time decay differential is the primary source of profit.
• Implied Volatility (Vega): An increase in implied volatility typically benefits a calendar spread because longer-dated options are more sensitive to volatility changes than shorter-dated ones.
• Underlying Price Movement: The strategy works best when the price of the underlying asset stays near the strike price at the short option’s expiration.

Key Features of Calendar Spreads

1. Neutral to Mildly Bullish/Bearish Strategy:
   • Works well in stable markets with low volatility.
2. Low Initial Cost:
   • Requires a lower capital investment compared to other strategies like straddles or strangles.
3. Defined Risk:
   • The maximum risk is limited to the net debit paid to establish the spread.
4. Profit Potential:
   • Profits are maximised when the underlying price is near the strike price of the options at the short option’s expiration.

Advantages of a Calendar Spread

1. Time Decay Advantage:
   • Exploits the faster decay of the short-term option relative to the long-term option.
2. Volatility Benefit:
   • Gains value if implied volatility increases, especially for the long option.
3. Low-Cost Strategy:
   • Calendar spreads are generally inexpensive compared to other advanced options strategies.
4. Flexibility:
   • Can be adjusted or rolled into different positions if the market moves unexpectedly.

Disadvantages of a Calendar Spread

1. Requires Stable Markets:
   • Calendar spreads are less effective in highly volatile markets or when the underlying asset moves significantly away from the strike price.
2. Implied Volatility Risk:
   • A sudden drop in implied volatility can reduce the value of the spread.
3. Complexity:
   • Requires a good understanding of options pricing, implied volatility, and time decay.
4. Limited Profit Potential:
   • The strategy has a capped profit, which occurs when the underlying price is near the strike price at the short option’s expiration.

How to Set Up a Calendar Spread

1. Choose the Underlying Asset:
   • Select a stock, ETF, or index with moderate price volatility.
2. Determine Strike Price:
   • Select the strike price near the current price of the underlying asset, as calendar spreads work best in stable markets.
3. Select Expiration Dates:
   • Buy a long-dated option (e.g., 3 months out) and sell a shorter-dated option (e.g., 1 month out).
4. Enter the Trade:
   • Place both orders simultaneously to establish the spread.
5. Monitor and Adjust:
   • Keep track of the underlying asset’s price, implied volatility, and time decay. Roll or adjust the trade if needed.

Example of a Calendar Spread

• Underlying Asset: Stock XYZ trading at £100.
• Setup:
  • Buy 1 XYZ call option with a £100 strike price, expiring in 90 days (cost: £5.00 premium).
  • Sell 1 XYZ call option with a £100 strike price, expiring in 30 days (receive: £2.50 premium).
• Net Debit: £2.50 (cost of long call minus premium received from short call).
• Scenario:
  • If the stock price remains near £100 at the short option’s expiration, the short call expires worthless, while the long call retains value, resulting in profit.

When to Use a Calendar Spread

• Neutral Market Outlook:
  • Best used when you expect the underlying price to remain near the strike price.
• Low Implied Volatility:
  • Ideal when implied volatility is low, with an expectation that it will rise.
• Earnings Reports or News Events:
  • Can be used around key events to capture volatility changes while limiting risk.

Practical and Actionable Advice

To trade calendar spreads effectively:

• Start Small: Begin with small positions until you fully understand the strategy.
• Watch Implied Volatility: Enter trades when volatility is low and avoid high-volatility environments.
• Adjust if Needed: Roll the short option to a new expiration if the underlying price moves significantly.
• Risk Management: Always use position sizing and risk management to limit potential losses.

FAQs

What is a calendar spread?
A calendar spread is an options strategy where you buy and sell options of the same strike price but different expiration dates.

How does a calendar spread make money?
It profits from time decay, stable underlying prices, and increases in implied volatility.

What are the risks of a calendar spread?
Risks include significant price movement in the underlying asset and sudden drops in implied volatility.

Is a calendar spread a bullish or bearish strategy?
It is typically a neutral strategy but can be adjusted for mildly bullish or bearish market views.

What happens if the short option expires worthless?
If the short option expires worthless, the long option remains active, allowing for potential further profits or adjustments.

Can calendar spreads be used in volatile markets?
They are best suited for low-volatility markets, as large price movements can reduce their effectiveness.

What is the maximum loss in a calendar spread?
The maximum loss is the net debit paid to establish the trade.

How does implied volatility affect calendar spreads?
An increase in implied volatility increases the value of the long-dated option, benefiting the spread.

Can calendar spreads be used for earnings trades?
Yes, they are often used to capture implied volatility changes before earnings announcements.

What is the difference between calendar and diagonal spreads?
A calendar spread uses the same strike price, while a diagonal spread involves different strike prices.

Conclusion

A calendar spread is a versatile options strategy that leverages time decay and implied volatility to generate profits in stable or mildly trending markets. By carefully selecting strike prices, expiration dates, and monitoring market conditions, traders can use this strategy to achieve consistent returns while managing risk effectively.