Options trading strategies can range from simple to complex, with one such nuanced approach being the calendar spread. In this article, we'll take a deep dive into the specifics of calendar spreads, their advantages and risks, and provide real-world examples.
What is a Calendar Spread?
A calendar spread, also known as a horizontal spread or time spread, is an options strategy that involves buying and selling two options of the same type (either puts or calls), same strike price but with different expiration dates. Traders employ this strategy hoping to take advantage of the time decay in options, which is faster for options with shorter expiry. The strategy involves selling or "writing" an option with a shorter expiration date and simultaneously buying an option with the same strike price but a longer expiration date. The aim is to benefit from the accelerated time decay of the near-term option sold, which ideally results in a profitable trade when the near-term option expires worthless.
How Does a Calendar Spread Work?
Let's look at an example for better understanding. Suppose a trader is analyzing stock XYZ, currently trading at $50 per share. The trader expects the price to remain relatively stable over the next two months, and decides to implement a calendar spread. The trader sells a one-month call option on XYZ with a strike price of $55 for a premium of $1 (i.e., $100 total as options contracts are typically in 100-share blocks). Simultaneously, they buy a two-month call option on XYZ with the same strike price of $55, but this time the premium is $2 (i.e., $200 total). This results in a net debit (or cost) of $1 ($200 - $100) for the trader to set up this trade. If the price of XYZ stays under $55 over the next month, the near-term call option will expire worthless. However, the long-term call option will still have some value. The trader will benefit if the time decay of the short-term option is greater than that of the long-term option. If executed correctly, the remaining long-term option will still be worth more than what the trader paid for the spread.
Advantages and Risks
A primary advantage of calendar spreads is that they can profit from the passage of time, rather than relying on the stock's movement. If the underlying stock stays relatively stable or moves very slowly, the short-term option will lose value more rapidly than the long-term option due to time decay, making the spread more valuable. However, there are risks associated with calendar spreads. If the stock makes a significant move, in either direction, it could result in a loss. A sharp move up would make the short-term call option go in-the-money, potentially resulting in assignment for the trader who sold the call. A sharp move down, on the other hand, could reduce the value of both the short-term and long-term options, making it harder to profit from the spread. Another risk is changes in implied volatility. If implied volatility increases, it tends to increase the price of options. Since a calendar spread involves being short an option and long an option, changes in implied volatility can have mixed effects. However, longer-term options tend to be more sensitive to changes in implied volatility, so an increase in implied volatility could potentially make the spread more valuable.
Calendar spreads in options trading are a complex strategy that relies on the effects of time decay and the stability of the underlying asset. While they can offer a unique way to profit from stagnant or slowly moving stocks, they carry risks such as sharp price moves and changes in implied volatility. As always, traders should thoroughly understand these dynamics and consider their risk tolerance before employing these strategies.