Calendar spreads are the combination of buying and selling two contracts with each having different expiration dates. With calendar spreads time decay is your friend. You can go either long or short with this strategy. It’s an excellent way to combine the benefits of directional trades and spreads.
Table of Contents
- What Are Calendar Spreads?
- How Do Call Calendar Spreads Differ From Put Calendar Spreads?
What Are Calendar Spreads?
Options have many strategies that allow you to profit in any market and calendar spreads are just such a strategy. Who doesn’t like being able to make money in a sideways market as well as up and down ones? Watch our video on how to trade them.
Options are different, however. You can’t pump and dump options or the large cap stocks that trade options.
You get real time alerts with entries and exits. All without the manipulation and pumping. And you can use calendar spreads to trade our alerts.
Calendar spreads are useful in any market climate. Ultimately, utilizing this strategy is an effective way to minimize risk. If your objective is to use calendar spreads for income, then the good news is that calendar spread earnings tend to be higher than that of other debit or credit spreads.
With this trading strategy, time decay is your friend. Also, with knowledge of the proper management techniques, you can do well for yourself trading calendar spreads. Check out our trade rooms if you want to see options trading in action.
How Do Calendar Spreads Work?
To utilize a calendar spread strategy, you buy and sell two options. You may trade two calls or two puts, but each is the same type. Additionally, you use the same strike price for both.
The only difference is the expiration dates. For example, you may create one option that expires in a month, then set the second one to expire in two months. Since the difference is the dates, calendar spreads are also called “time spreads” or “horizontal spreads.”
You can go long or short on your spread. To initiate a long calendar spread, you sell the option with the earlier expiration date and buy the option with the later expiration date.
For a short calendar spread, you do the opposite. You buy the option that expires earlier and sell the option that expires later. Buying short term and selling long term is also called a “reverse calendar spread.”
Using Volatility to Your Advantage
For your calendar spread, you want your strike price to be at or near the price of the underlying asset. Your objective is to profit off of volatility and time.
The longer-term option is affected more significantly by higher Vega (changes in volatility). Therefore, the increase in implied volatility impacts this strategy in a positive manner.
Just be aware that both of the options that you trade will usually be subject to different implied volatility’s. Check out our service if you want to learn more about the Greeks and how they affect options trading.
How to Use Time to Your Advantage
Time should have a positive effect on the near-term option until it expires. Then the value of your later-term option should erode over time.
The reason for this is because the theta (rate of decay) increases the closer you get to the expiration date. As a result, the calendar spread requires management.
You’ll spend time monitoring and possibly adjusting them. Before setting up your spread, assess your risk profile.
A tool like the ThinkorSwim platform makes this easy. Just use the Analyze tab to create a graph.
Check the break even range for the price of the underlying asset on the day when the near-term asset expires. If the price is too close to the top or bottom of the breakeven range, then you may need to make an adjustment.
How Do Call Calendar Spreads Differ From Put Calendar Spreads?
What is a call calendar spread? Summed up simply, a call calendar spread utilizes two calls. Meanwhile, a put calendar spread utilizes two puts. With options, you may go long or short on a call or a put. With a calendar spread, both options are the same type. However, you can create long-call or short-call calendar spreads. Likewise, you can create long-put or short-put calendar spreads.
In the case of all of these strategies, you create both options with the same strike price. Note that you only use different strike prices for a variation on this strategy, like when you create a diagonal calendar spread.
Now, let’s look at these strategies in a little more detail.
Long Call Calendar Spread
With this spread, your near-term outlook is neutral to bearish. However, your longer-term outlook is bullish.
You go short on your call option that expires earlier and long on your call option that expires later. Your objective is to profit from the price of the underlying asset remaining steady or falling by the time your near-term option expires.
If it expires worthless, then you own the option that expires later free and clear. Your maximum gain on this strategy is potentially unlimited, while your maximum loss is the net premium.
Short Call Calendar Spread
To initiate this strategy, you buy your call option that expires earlier and sell your call option that expires later. Your objective is to profit from a sharp move in the price of the underlying asset for your near-term option.
In this case, your maximum gain on this strategy is the net premium. However, this strategy is riskier because your maximum loss is potentially unlimited.
Long Put Calendar Spread
With this spread, your near-term outlook is neutral to bullish. However, your longer-term outlook is bearish.
You sell your put option that expires earlier and buy your put option that expires later. Your objective is to profit from the price of the underlying asset remaining steady or rising slightly for your near-term option.
If it expires worthlessly, then you own the option that expires later free and clear. Your maximum gain on this strategy is the strike price minus the net premium, while your maximum loss is the net premium.
Short Put Calendar Spread
To initiate this strategy, you buy your put option that expires earlier and sell your put option that expires later.
Your objective is to profit from a sharp move in the price of the underlying asset for your near-term option.
In this case, your maximum gain on this strategy is the net premium. However, your maximum loss is the strike price minus the net premium, and this loss could be substantial.
For example, you create a near-term buy position and sell the longer-term position if you believe the price will rise. Unless you own the underlying commodity, a single-leg option is riskier.
Creating a spread enables you to potentially profit from both positions or at least have one leg offset losses from the other leg. Another benefit of utilizing futures calendar spreads is lower margin.
Since the two positions essentially hedge each other, this lowers the price volatility. What makes futures different is that supply and demand have the greatest effect on calendar spreads.
Consider the case of a sufficient supply of wheat, for instance. The “cost of carry” price generally causes the longer-term position to trade much higher than the near-term position.
Meanwhile, the opposite occurs if the commodity is in short supply. In that case, the near-term positions would trade higher than the later-term positions. The market itself rations demand.
If you trade calendar spread futures, then historical data plays an important role in your analysis. See how the commodity has performed in the past during that season under similar circumstances.
Calendar spreads are a valuable strategy to add to your options trading arsenal of knowledge. It’s one of any number of strategies that you can deploy besides others like straddles, strangles, or wingspreads.
Additionally, it’s not only important to understand the various options strategies, but also when it’s best to use which one.
If you’d like to learn more, like the role of the Greeks, the risks associated with your choice of expiration date, and when to buy or sell, then we can show you.
If you need more help, take our options trading course.