True to its name, a calendar spread (sometimes known as a "horizontal spread") takes advantage of the calendar, through the purchase and simultaneous sale of options with the same strike price, but different expirations. Calendar spreads take advantage of time-value differentials during periods of reduced volatility (i.e., trading-range environments). Typically a neutral strategy, this spread can be bullish or bearish as well, depending on the options employed. Net losses are limited to the premium paid at the time the spread is initiated, while maximum profit is dependent upon the time value contained in the longer-dated option at the time the shorter-term contract expires.
The most frequent use of the calendar spread is probably the basic rolling out of a position expiring shortly to a later month. An options trader might simply roll a sold call position out to a later month to collect additional premium and keep the stock from being called away.
There are also instances when a calendar spread is initiated through the simultaneous sale and purchase of both options, rather than essentially closing one option to open another. The calendar spread is also an exceptionally useful trade for the investor with a good grasp of the underlying stock and the upcoming events likely to affect it.
A trader wishing to buy or "go long" using a calendar spread would buy the longer-dated option and sell the shorter-dated one. This move would also be considered a debit spread, since the option being purchased should cost more than the one being sold, requiring a net cash outlay even before commissions. Conversely, calendar spread can also be sold (with the trader "going short") where the earlier-dated option is purchased and the later-dated position of the same type (i.e., put or call) is sold.
The most ideal calendar-spread trade occurs when near-month implied volatilities are high relative to options with a long life. Optimally, a spread trader will initiate a calendar spread when the stock is expected to trade in a narrow consolidation pattern over the short term, reducing implied volatilities on the shorter-term sold option (or increase on the purchased option). The best-case scenario for a calendar spread is that the sold option expires out of the money, while the purchased option retains time premium.
Calendar Debit Spread (Long) - Example
- XYZ shares trading at 68 on March 5
- XYZ May 65 put sold at $4.60 per contract
- XYZ September 65 put bought at $8.10 per contract
- Net debit = ($8.10 - $4.50) = -$3.50
In this hypothetical example, XYZ has been trading in a sideways range, which the investor expects to continue for at least 2 more months. Using put options, he opens a bearish calendar debit spread, selling the short-term May 65 put (out of the money by $3) and buying the longer-dated September 65 put.
Unless XYZ was able to move significantly below the 65 strike – or a large move in the opposite direction transpired very quickly – the spread would likely prove profitable. The best-case scenario 2 months out is if XYZ trades close to 65 for the life of the trade. The sold position would thus expire worthless or with very little intrinsic value, allowing the trader to retain all or most of the premium collected from the option sale. The September option would be near the money with 4 months left in time premium as of May expiration.
With the May contract now off the books, the trader holds a bearish position, with the September 65 put still open. This option can be sold, keeping the time premium as profits, or it can be kept in the investor's portfolio if the outlook for the stock is bearish-to-neutral.
The table below details various profit/loss scenarios depending on XYZ price action. Profits are based upon the difference in the values of the 2 options at various times and stock prices, divided by the initial debit of $3.50.
If the investor had decided to keep the purchased September 65 put, XYZ would have to close at $58.60 at September options expiration in order to retain the profits captured in May. This would give the XYZ September 65 put $6.40 in intrinsic value at expiration.
In this case, any decline below $58.60 by September expiration would be additional profit from May, while a close above this threshold would cut into profits banked 4 months earlier. Note that this example does not account for transaction costs or bid/ask spreads between the options. In reality, both the sold and purchased options would likely give up some ground at the hands of market makers. Additionally, in this hypothetical example, one assumes that implied-volatility readings are relatively steady.
As you can see from the example, the idea with buying a calendar spread is to pocket in some premium during an expected short-term lull before the bigger storm you are expecting. That is, the stock makes little movement, allowing the sold put to expire worthless, while the longer-term position is potentially held open to benefit from a later decline in the underlying shares. Additionally, the shorter-dated premium collected helps defray the cost of the option purchased. The concepts can also be employed in a bullish calendar spread, trading calls with the same strike price but divergent expiration dates.
Calendar Credit Spread (Short) - Example
- XYZ shares trading at 68 on March 5
- XYZ May 65 put bought at $4.60 per contract
- XYZ September 65 put sold at $8.10 per contract
- Net credit = ($8.10 - $4.50) = $3.50
Unlike the long calendar spread, which benefits from a lack of movement that results in a worthless expiration for the sold position, the shorted calendar spread (not typically employed) fares best when the underlying stock makes a quick and dramatic move in either direction. If the option with the earlier expiration sees its time value erode quicker than its longer-term counterpart, the credit spread will be negatively impacted.
The last major issue left to review with regard to the calendar spread is the directional exposure of the trade. This can vary rather dramatically, especially when the first option nears expiration and the stock is hovering near the strike price.
Under these circumstances, if a trader is long a calendar spread (having sold an about-to-expire call and purchased a longer-dated one), he is essentially short the stock and long the long-dated call, which is the economic equivalent of a long-dated put. This volatility can be avoided by covering the short-dated option shortly before its expiration, keeping in mind that those who would sell it recognize the potential value and price it accordingly. And if the position is covered, a big portion of the advantage of the spread's advantage is relinquished.
The calendar spread is a simple trade with a lot of nuances. The key is to monitor the trade carefully in the last week of the first option's life, no matter what side of the trade has been played.
Of course, options players like to make things complex when they want to, which means calendar spreads can occasionally take on a "diagonal" element, when the strikes are different as well as the expiration month. (In this case, the only likeness between the contracts is the underlying stock and the type of option – call or put).
As simply as possible, a diagonal spread involves the sale of a short-term call (or put) and a purchase of a longer-term call (or put). The options traded will have different strike prices. Both risk and profit are limited, and the impact of time decay is helpful for retaining the premium collected on the sold trade.
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