Everything You Need to Know about Calendar Spreads

Everything You Need to Know about Calendar Spreads

 A calendar spread is defined as an investment strategy for derivative contracts in which the investor buys and sells a derivative contract at the same time and same strike price, but for slightly different expiration dates. Putting calendar spreads strategies to use entails purchasing and selling one type of option or futures contract at the same time. For example, David the investor predicts XYZ Company to have a flat to slowly increasing price trend. To benefit from this, he chooses to buy options contracts after the spread strategy. XYZ Company is currently trading at $200 per share. David buys a longer-term six-month call option with a strike price of $206, while also selling a shorter-term two-month call option with a strike price of $206. David’s maximum profit is unlimited after the short-term option expires. 

How Calendar Spreads are Used

 Calendar spreads benefit companies when the underlying security is expected to have neutral to moderately rising price trends. This strategy is sometimes also called a horizontal spread. A typical set up involves selling a front-month option and buying an option in a later period or further out in the future. Another option is to set up the trade using weekly periods. The more into the future the trader goes to purchase the option, the more costly the trade becomes. 

 A market in Backwardation is an optimal time to enter calendar spreads due to the front month volatility being higher than the back month. Calendar spreads typically benefit from rising volatility after the trade takes place. It has been observed that a short-dated option sold will incur faster time decay than its longer-dated opponent. Considering the underlying item stays within the profitable area, the trade will be successful!

 A calendar call spread is a valuable strategy to add to a company’s options trading bank of information. It is one of many strategies that companies can use to maximize their profits and ensure success. Not only is it good to know what options there are, it is also beneficial to know when to use each one to ensure maximum benefits to the organization. 

It is important to do your research and find the methods that work best for you and your company!

Short-Term vs Long-Term Calendar Spreads

 The main difference between short-term and long-term calendar spreads is the price of the trade. Longer-term trades have an increased sensitivity to changes in the volatility of the underlying asset, but that doesn’t mean that they are guaranteed to be more profitable if the volatility is high. Each period on the curve is impacted differently to these changes. Research shows that a spike in volatility will actually impact short-term options more than long-term options. 

 Another difference is the time in which you need to initiate the spreads. To begin a long-term spread, the option is sold with the earlier expiration date and a new option is purchased with the later expiration date. The opposite is done for short-term calendar spreads. 

Understanding Maximum Gains and Losses

 The amount gained or lost with the spread strategy depends on the amount invested. Calendar spreads are debit spreads, therefore the most that a trader can lose is the number paid to enter the particular trade. The sold option is usually shorter-term and cheaper than the longer-term option that is bought which concludes in a net debit for the investor. In order to suffer a loss, the underlying stock would have to make a significantly large move. 

 On the other hand, the maximum gain cannot be figured in advance due to the fact that it is not possible to predict what the back-month option would be trading for when the front-month option expires. This is because the predicted volatility is subject to change. The perfect scenario for the trade using this strategy would be that the stock ends close to the short strike at the expiration of the short-term option. If all goes as planned, this would result in an increase in implied volatility in the back-month option. This increase assists to balance out any negative trends from time decay.

 Similar to the maximum gain, the breakeven price cannot be calculated but it can be estimated beforehand.

Risks Associated with Early Assignment

 As with anything pertaining to the stock exchange, calendar spreads do come with their share of risks. With this strategy, there can be a risk of early assignment when having a near-term option position in an individual stock. This particular risk can be decreased by trading Index options, however these tend to be more costly. Early assignment only happens on call options in the event there is an approaching dividend payment. Investors or traders will “exercise” the call to take ownership of the share before it expires and receive the dividend. 

 Option market players will usually advise traders to avoid exercising option contracts early because there is a likelihood that the option premium gain possibility could be lost as the expiration date nears. While frowned upon, there are cases when exercising the option early is worth it. Let’s say you have a call option that is in-the-money prior to the underlying stock going ex-dividend. By taking an early assignment, one could capture the dividend and make up for the loss of the premium caused by the earliness. 

 Overall, the risk is highest when a stock trades ex-dividend. If the stock is trading lower than the sold call, the risk is then low. One way to avoid early assignment risk is to trade with stocks that do not pay dividends. Another way is to trade European style indexes that do not have the ability to be exercised early. While this should be taken into consideration, it should not be the most important factor used when determining which underlying asset to trade. 

Reasons to Initiate a Horizontal Spread

• Increased profitability from price volatility
• Increased profitability from time decay
• Increased profitability from neutral price movements of the underlying security
• You are a more experienced investor with a strong knowledge of derivative contracts

How to Use Calendar Spreads and Time to Your Benefit

 Creating calendar spreads allows you to potentially benefit from both sides or at least have one side offset losses from another side. Lower margins is another potential benefit since the two sides complement each other and this, in turn, decreases the price volatility. Price volatility is a common measure of the reasonable scale of price movement over a period of time and is used in many financial calculations of option prices, so it is important to keep this low. In simpler terms, it is a term used to measure price fluctuations of a trade.

Why is Volatility Important to Take Into Consideration?

 Calendar spreads are long vega trades, meaning they thrive on rising volatility after the trade has occurred. Vega is the greek that measures a position’s exposure to changes in volatility. For example, if a position has a positive vega overall, it will not benefit from falling volatility. 

There Are Many Types of Calendar Spreads

 What makes calendar spreads difficult strategies to understand is there are so many of them to use! Some options include the double calendar spreads, long calendar spreads, long calendar put spread, and short variations. The covered call option strategy is by far one of the simplest and popular ones. If used correctly, it can enhance returns from holding stock and return income by writing call options on that particular asset. Like the ones mentioned before, this position has two legs, with only one involving options. These are the long position and short position. 

 In the covered call option, covered means that the long position in the underlying asset serves as the guard to protect against possible losses from its short call counterpart. An uncovered or naked call contains unlimited possible losses and there is no limit on how high the price can reach. This sounds like a more risky option under the calendar spreads strategy database. However, the possible infinite losses would be balanced by an increase in the position’s underlying value. 

FAQs