Calendar Spread – Option Strategy
This article is in regards to the calendar spread trade. When an option remains in a position which the expiration date is several months away, it is seen that time decay is comparatively slow. With the passage of time, the rate of time decay or the option’s theta increases. When the option’s expiration date settles within less than thirty days to expiration, time decay changes rapidly. Typically the Calendar spread is utilized in this situation.
Calendar Spread – Horizontal Trade
In a characteristic horizontal type calendar spread, one sells an option and as well as purchases another option of the identical type whatever it might be i.e. put or call on the same underlying stock and at the identical strike price however with a further expiration. When number of month’s remains for the option prior to its expiration, the time decay is comparatively slow. With the passage of time the rate of time decay increases. The time decay goes into full force, when the option has less than thirty days remaining. Calendar spreads take advantage of this typical situation. In a characteristic horizontal type of calendar spread, one sells and simultaneously buys another option of the identical type which may be put or call one the identical underlying stock and at the identical strike price, having more out expiration. Here is one illustration of calendar spread mentioned below for clear understanding.
Calendar Spread – Example
Suppose one option trader wants to take position in stock market applying the technique of calendar spread and he or she opts for selling or writing one for the month of June 50 call for which the underlying price is 50.00 and for selling the call one receives 1.96 as premium while the expiration days is due after thirty days and implied volatility is 32.6% and at the same time he or she purchases one 50 July call for the same underlying and pays an amount of 2.53 and the relevant time due for expiration against this call is 58 days and the corresponding implied volatility is 29.4% Therefore, the net cost of the spread become -0.57. Now what happens is that in case of June 50 call the loss of premium takes place quickly in comparison to the July 50 call, resulting in the spread to extend since in this case vale of the spread will enhance. For trading purposes the best situation in respect of the underlying will be when the same is trading at 50 and the June 50 call becomes worthless because of expiration. However, the July 50 call having twenty eight days remaining still in place of fifty eight days will be having time premium. Assuming implied volatility maintaining the same 29.4% level, the premium for the July 50 call will be 1.72 in view of the market price. Therefore, the calendar spread that cost one 0.57 will now stand at 1.72 thereby resulting in a profit for 1.15 which is nearly two hundred percent return within one month, although cost of ask/bid slippage and commission are to be deducted.
However, for the above trade to become fruitful, the market has to remain in a range bound and better if it moves in a narrow range. Any big jump in market movement be it in the down side or in the upside will entail loss for the trader. The option one sells must be overvalued in comparison to the option one purchases. It becomes helpful if implied volatility increases. This will enhance the premium for time value of the options one buys that have much time remaining in comparison to the options one sells in calendar spread. One may remember from the section of Option Basics that vega of an option determines the changes in price of the option corresponding to percentage change in volatility. Vega reduces as the date of expiration for the option approaches. In case of calendar spread, the options one purchases have more time left and therefore a bigger vega compared to the options one sells. This denotes that an enhancement in implied volatility will make the price of the option one purchased to enhance more in comparison to the options one sold.
In addition, if one remains in the calendar spread till the options one sold expire, they expires having no time value remaining while the options one purchased will have time value still remaining. When one finds a stock for a calendar spread, one should ensure regarding the possibility of profit factor, which is the price range that the underlying has to maintain for making this method to become profitable. One should also note that what will occur to one’s position if changes in implied volatility takes place and by doing so one will be able to enter into a better trading opportunity. Therefore, in order to make trading by the utilization of calendar spread method one has to be careful about other conditions of the market.
If you would like to discover how to learn more about the calendar spread strategy – watch our free trading video and join our free options trading newsletter – o do so – click here