The calendar spread is one of the most popular options strategies for many investors around the world. It allows you to maximize profits while minimizing losses. So, what exactly is it?
What is a Calendar Spread?
According to tastytrade, a calendar spread is a futures strategy employed by entering long and short positions simultaneously on the same asset, with the only difference being the maturity dates.
When employing the calendar spread strategy, you can use the same strike price to go short on a nearer-term option and buy a long-term contract on a longer-term contract. Basically, the longer the contract, the more expensive it will be.
Calendar spreads are also known as horizontal spreads. It is also called a diagonal spread if one uses two different strike prices for each month.
Understanding Calendar Spreads
A calendar spread trade involves selling an option with a short-term maturity date and the simultaneous purchase of an option with a longer-term maturity.
A reverse calendar spread is the opposite of a typical calendar spread since it takes the opposite direction. Simply put, it involves buying an option with a shorter-term maturity and selling a longer-term option at the same strike price.
Like any other futures strategy, the purpose of this trade is to increase implied volatility or profit from the passage of time.
The strike prices are always kept close to the underlying asset’s price since the goal is to profit from volatility and time. Here, the trader takes advantage of the nature and behavior of the options’ dates when time and volatility change.
An increase in implied volatility would positively impact this options strategy since changes in volatility affect longer-term options more.
Likewise, the passage of time would positively impact this options strategy up until the short-term option matures. After this point, the strategy becomes a long call whose value decreases over time. Typically, an option’s theta (rate if time delay) increases as its maturity date approaches.
Maximum Loss
The maximum loss a trader can make is the amount they used to enter the trade. As such, a calendar spread is a debit spread. The trader sells the shorter-dated option, which is cheaper than the longer-dated option being bought. This results in a net debit for the trader.
A calendar spread is safe in that for a trader to make a complete loss, the underlying option would need to make a massive move.
Maximum Gain
The maximum gain cannot be calculated or otherwise estimated in advance since it is impossible to know how much the back-month option will be trading when the front-month option matures.
The stock needs to end near the short strike when the near-term option expires for maximum gains to occur.
How Volatility Impacts the Trade
A calendar spread is a long vega trade. This means that it benefits from an increase in volatility after placing the trade.
If a position has a positive vega, it will benefit from increased volatility. Likewise, if a position has a negative vega, it will benefit from falling volatility.
How Theta Impacts the Trade
A calendar spread makes money over time. This makes it a positive theta trade. This is because the short-term call suffers a faster time decay than the bought longer-term call. This is especially true if the bought longer-term call is further away.
Risks
Being a neutral trade, you have to risk that the underlying stock’s price may rise or fall sharply, resulting in losses.
Another common risk is the assignment risk. If the short call is in the money, and the stock is trading ex-dividend, then the trade is at its highest assignment risk.
You may also face expiration risk if the stock is trading below or above the short call.
Also, being a theta trade, if volatility falls just after the trader initiates the trade, the position will likely suffer losses.
Conclusion
Using the calendar spread options strategy is a pretty cool and effective way to maximize profits. That being said, you should do careful research on the subject before you invest your hard-earned money.
