Understanding Calendar Spreads
Calendar spreads, also known as horizontal spreads or time spreads, are options strategies that take advantage of the passage of time and/or changes in implied volatility. They are designed to be low-risk and directionally neutral, making them a popular choice among traders. In this article, we will delve into the mechanics of calendar spreads and explore their applications in futures and options trading.
The Basics of Calendar Spreads
A calendar spread involves using two options contracts with the same strike price but different expiration dates on the same underlying security. The trader sells the near-term option (front month) and holds the longer-term option (back month) simultaneously. This creates a debit spread, as the cost of establishing the position is higher than the premium received from selling the near-term option.
Both call and put options can be used to construct a calendar spread, but the two options should be of the same type. The strike prices are typically chosen to be close to the current spot price of the underlying asset, with the expectation that there will be minimal changes in price. Significant price movements can result in losses for the investor.
The maximum loss in a calendar spread is limited to the net debit paid to establish the position. The long leg of the spread helps to mitigate the risk of the short leg. Calendar spreads can be employed with a neutral, bullish, or bearish outlook. If the options used are at-the-money, the investor has a neutral outlook. Adjusting the strike prices slightly in one direction or the other defines a bullish or bearish outlook.
When slightly different strike prices are used in a calendar spread, it is known as a diagonal spread. The maximum profit occurs when the short position expires unused, and the long position becomes in-the-money. Increases in implied volatility, coupled with minimal changes in the underlying stock price, result in higher option prices. Traders can capitalize on this scenario by selling the long option before its expiration.
Applications of Calendar Spreads
Calendar spreads are employed by traders for various reasons. One of the primary advantages of calendar spreads is their ability to minimize the effects of time decay. The longer-term option tends to retain its value better than the shorter-term option as time passes. Traders can profit from the time decay of the near-term option while still maintaining exposure to the underlying asset through the longer-term option.
Another benefit of calendar spreads is their potential to profit from changes in implied volatility. If implied volatility increases without significant changes in the underlying stock price, the prices of the options involved in the spread can rise. Traders can capitalize on this volatility expansion by selling the long option at a higher price.
Calendar spreads are most profitable when the underlying asset remains relatively stable and does not experience significant price movements until after the near-month option expires. In this scenario, the trader can benefit from the time decay of the short option while holding the longer-term option, which may appreciate in value if the stock price moves in the desired direction. Calendar spreads offer traders a versatile strategy for capitalizing on time decay and changes in implied volatility. By simultaneously entering into long and short positions on options with different expiration dates, traders can maintain a directionally neutral position while potentially profiting from the passage of time and volatility fluctuations.
As with any trading strategy, it is essential for traders to thoroughly understand the risks and nuances of calendar spreads before implementing them in their trading activities. Additionally, staying informed about market conditions, monitoring the performance of the underlying asset, and adjusting the spread as necessary are key elements of successful calendar spread trading.
Summary
A calendar spread is a strategy also known as a horizontal spread or time spread, in which the investor uses two options contracts, with the same strike price, on the same underlying security, but with different expiration dates.
The trader will “write” (sell) the near-term one (front month) and hold the one with the more distant expiration date (back month) long. This is a debit spread, since the investor will pay more to establish this position than is received from the short sale of the near-term option: longer-term options have a greater time value than short-term options.
Either calls or puts can be used to establish a calendar spread, but the two options should be of the same type.The investor will choose strike prices close to the current spot price of the underlying and hopes that there won't be much of a change in price. If the price of the underlying decreases or increases too much, it will result in a loss for the investor.
The good news is that the most the investor can lose is the net debit from establishing the position. The long leg will cover the risk of the short leg. Calendar spreads can be done with a neutral, bullish, or bearish outlook. If the options being used are at-the-money, the investor is neutral. Using the same strike prices slightly out of the money in one direction or the other will define a bullish or bearish outlook.
Using slightly different strike prices can be called a diagonal spread. The maximum profit is taken if the short position expires unused and the long position goes into the money. Increases in implied volatility without much change in the stock price of the underlying will result in increases in the prices of the options. The trader can sell the long option before expiration in this instance.