What Are Calendar Spreads?
A calendar spread is an advanced options trading strategy that involves simultaneously buying and selling options contracts of the same type (either call options or put options) on the same underlying asset and with the same strike price, but with different expiration dates. This strategy, which falls under the broader category of options trading strategies, is also frequently referred to as a "time spread" or "horizontal spread" due to its emphasis on the temporal component of options pricing. Traders typically implement calendar spreads to profit from anticipated differences in time decay and implied volatility between the two option legs.
History and Origin
The concept of options contracts dates back to ancient times, with early forms of speculative agreements existing as far back as ancient Greece. However, the formalization and standardization of modern options trading began much later. A pivotal moment in the history of options occurred with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Cboe was founded to provide a regulated and transparent marketplace for exchange-listed options, initially offering call options on 16 underlying stocks.5 This innovation dramatically transformed the accessibility and liquidity of the options market, moving away from fragmented over-the-counter dealings to a centralized exchange environment.
Key Takeaways
- A calendar spread involves buying and selling options of the same type and strike price but with different expiration dates.
- The strategy aims to profit from the differing rates of time decay and implied volatility between the near-term and far-term options.
- Calendar spreads can be constructed using either call options (call calendar spread) or put options (put calendar spread).
- They are generally considered a market neutral strategy, although directional biases can be introduced.
- The maximum profit potential is limited, as is the maximum loss, making them a defined-risk strategy.
Formula and Calculation
The profit or loss of a calendar spread depends on the difference in premiums between the two option contracts. A common form is the long calendar spread, where a trader sells a near-term option and buys a far-term option.
Net Debit (Cost of the Spread):
Maximum Profit:
The maximum profit for a long calendar spread is not precisely calculable at initiation because it depends on the implied volatility and the exact price of the underlying asset at the expiration of the near-term option. However, profit is generally maximized when the underlying asset's price is at or near the chosen strike price when the near-term option expires.
Maximum Loss:
The maximum loss for a long calendar spread is limited to the initial net debit paid when establishing the position. This occurs if the underlying asset moves significantly away from the strike price, causing both options to expire worthless (if out-of-the-money) or the long option to lose significant value while the short option also expires worthless.
Interpreting the Calendar Spread
Interpreting a calendar spread primarily revolves around its sensitivity to time decay (Theta) and implied volatility (Vega). The strategy typically benefits from the faster decay of the near-term option compared to the slower decay of the longer-term option. This is because time decay accelerates as an option approaches its expiration date.
A long calendar spread generally has a positive Theta (it profits as time passes) and a positive Vega (it profits from an increase in implied volatility). Therefore, traders often implement this strategy when they anticipate a period of low volatility in the near term, followed by stable or slightly increasing volatility, or when they believe the market's current implied volatility for the near-term option is higher than that for the far-term option. The goal is for the short option to expire worthless or with minimal value, while the long option retains significant extrinsic value.
Hypothetical Example
Consider an investor who believes that Company XYZ's stock, currently trading at $100, will remain relatively stable over the next month before possibly making a move. To implement a long calendar spread using calls, the investor takes the following steps:
- Sell 1 month XYZ 100 Call Option: Sells a call option expiring in one month with a strike price of $100 for a premium of $2.00.
- Buy 2 month XYZ 100 Call Option: Buys a call option expiring in two months with the same strike price of $100 for a premium of $3.50.
The initial net debit for this calendar spread is $3.50 (long premium) - $2.00 (short premium) = $1.50. This represents the maximum potential loss.
Scenario at Near-Term Expiration (1 month later):
- If XYZ is exactly at $100: The near-term call expires worthless, and the investor keeps the $2.00 premium. The two-month call still has one month until expiration and might be worth, for example, $2.50 due to its remaining time value. The profit would be ($2.50 - $1.50) = $1.00 per share, or $100 per contract (less commissions). The investor could then sell another short-term call against the remaining long option to potentially generate further income.
- If XYZ moves significantly to $105: Both calls are in-the-money. The near-term call is exercised, and the investor is obligated to sell shares at $100. They might choose to exercise their long 2-month call to fulfill this obligation, or buy shares on the open market. The long call might be worth $5.00 or more, but the initial short position would have resulted in an assignment. This scenario highlights the need for active risk management.
Practical Applications
Calendar spreads are commonly used by traders to express a view on either stable price action or changes in volatility over time, particularly around earnings announcements, product launches, or other significant events that could impact an underlying asset. They can be employed as a means of hedging existing positions or for pure speculation. For instance, a trader might implement a calendar spread if they anticipate that near-term implied volatility is inflated due to an upcoming event, but that long-term implied volatility will remain stable or decrease after the event.
The strategy's reliance on time decay makes it particularly attractive when the trader expects the underlying asset to remain relatively stable until the near-term option expires. They are also used in situations where traders expect a significant difference in how future volatility is priced. Regulatory bodies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) oversee options markets in the U.S. to ensure fair trading practices and investor protection.4 The Options Clearing Corporation (OCC) serves as the central clearinghouse for listed options, ensuring the performance of options contracts and providing important disclosures like the "Characteristics and Risks of Standardized Options" document to investors.2, 3
Limitations and Criticisms
While calendar spreads offer defined risk and potential for profit in specific market conditions, they come with certain limitations and criticisms. One primary drawback is their limited profit potential. Unlike a simple long option position, a calendar spread's profit is capped, even if the underlying asset makes a significant favorable move. The strategy also requires careful management, particularly as the near-term option approaches its expiration date. Early assignment of the short option is a risk, especially for call options on dividend-paying stocks when the ex-dividend date falls before the short option's expiration.
Furthermore, accurately predicting the movement of implied volatility across different expiration cycles can be challenging. An unexpected surge or drop in implied volatility can significantly impact the profitability of the spread, particularly if the Vega exposure is not properly understood or managed. Research on option returns suggests that various factors, including the implied volatility surface, influence the performance of such strategies.1
Calendar Spreads vs. Diagonal Spreads
Both calendar spreads and diagonal spreads involve options with different expiration dates, leading to occasional confusion. The key distinguishing factor lies in their strike prices.
| Feature | Calendar Spread | Diagonal Spread |
|---|---|---|
| Expiration Dates | Different (one near-term, one far-term) | Different (one near-term, one far-term) |
| Strike Prices | Same | Different |
| Option Type | Same (e.g., both calls or both puts) | Same (e.g., both calls or both puts) |
| Primary Goal | Profit from time decay and implied volatility differences, often a market neutral view. | Profit from directional movement, time decay, and volatility differences. |
A calendar spread is a horizontal spread focused on exploiting differences in time value. A diagonal spread introduces a directional component by having different strike prices, allowing for more nuanced speculation on price movement while still leveraging the benefits of different expiration cycles.
FAQs
What is a long calendar spread?
A long calendar spread is an options strategy where you sell a near-term option and buy a longer-term option of the same type (call or put) and with the same strike price. The goal is to profit from the faster decay of the near-term option's time value.
What is a short calendar spread?
A short calendar spread is the opposite: you buy a near-term option and sell a longer-term option of the same type and strike price. This strategy typically benefits from increasing implied volatility and is often used when a significant price move is expected.
Are calendar spreads suitable for beginners?
Calendar spreads are generally considered intermediate to advanced options trading strategies due to their sensitivity to multiple factors like time decay, implied volatility, and the need for active management. Beginners are often advised to start with simpler strategies before exploring spreads.
Can calendar spreads be used with both calls and puts?
Yes, calendar spreads can be constructed using either call options (known as a call calendar spread) or put options (known as a put calendar spread). The choice depends on the trader's market outlook and desired exposure.