Calendar Spread: What It Is and How It Works

A calendar spread, also known as a horizontal spread or time spread, is a sophisticated options trading strategy that involves simultaneously buying and selling options with the same strike price but different expiration dates. This approach is typically used when a trader anticipates minimal short-term price movement in an underlying asset but expects more significant fluctuations in the long term.

What is a calendar spread?

A calendar spread is an options trading technique where a trader purchases and sells two options of the same type (either calls or puts) with identical strike prices but different expiration dates. This strategy allows traders to potentially profit regardless of whether the asset's price moves up or down, making it a neutral investment approach.

There are two main types of calendar spreads:

1. Calendar call spread: Involves buying a long-term call option and selling a short-term call option with the same strike price.
2. Calendar put spread: Involves buying a long-term put option and selling a short-term put option with the same strike price.

Both strategies aim to capitalize on the faster time decay of the short-term option compared to the long-term option.

How does the calendar spread strategy work in options trading?

The calendar spread strategy in options trading works by exploiting the differences in time decay and volatility between options with the same strike price but different expiration dates. It typically involves two key steps:

1. Selling a short-term option: The trader sells an option (call or put) with a near-term expiration date at the same strike price as the longer-term option they plan to buy. This provides immediate income and helps finance the purchase of the longer-term option.

2. Buying a long-term option: Simultaneously, the trader purchases an option of the same type (call or put) with the same strike price but a longer expiration date. The longer-term option has a slower rate of time decay, which is crucial for the strategy's success.

Examples of calendar spread

To better understand how calendar spreads work in practice, let's examine a few examples:

1. Long call calendar spread: A trader believes an asset trading at $50 will remain stable in the short term but may increase in value later. They sell a 1-month call option with a $50 strike price for $2 and buy a 3-month call option with the same strike price for $4. The net cost is $2, and the trader profits if the asset price stays near $50 until the short-term option expires.

2. Long put calendar spread: For an asset trading at $100, a trader expects little change in the near term but a potential drop later. They sell a 1-month put option with a $100 strike price for $3 and buy a 3-month put option with the same strike price for $6. The initial investment is $3, and the strategy is successful if the stock remains close to $100 when the short put expires.

3. Short calendar spread with calls and puts: This less common variant is used when a trader expects a significant price move but is unsure of the direction. It involves selling short-term call and put options while buying longer-term call and put options, all with the same strike price.

Conclusion

Calendar spreads are versatile options trading strategies that allow traders to potentially profit from time decay and volatility differences between options with different expiration dates. While they can be complex and carry certain risks, calendar spreads offer a unique way to approach neutral market conditions and capitalize on both short-term stability and long-term volatility. As with any trading strategy, it's essential for investors to thoroughly understand the mechanics and potential outcomes before implementing calendar spreads in their portfolios.

FAQ

How does a calendar spread work?

A calendar spread involves buying and selling options with the same strike price but different expiration dates. It profits from time decay and volatility changes, offering a lower-risk strategy.

Is a calendar spread bullish or bearish?

A calendar spread is typically neutral. It profits from time decay rather than directional price movements.

How profitable is calendar spread?

Calendar spreads can be profitable, offering low-risk returns. Profits stem from time decay and volatility changes. Success depends on market conditions and skilled management.

What is an example of a put calendar spread?

A put calendar spread involves buying a put option with a near-term expiration and selling a put option with the same strike price but a later expiration date.