Calendar Spread – Defined

In Future & Option market, a calendar spread also known as horizontal spread or time spread is a kind of spread trade which takes place by simultaneous buying of options or futures having the expiry at a specified date and sale of the similar instrument which has another expiring date. The legs of spread differs in expiration date only however the strike price and underlying market remaining same. Usually the case involves the buying of options or futures for a distant month and the sale of options or futures for a nearby month. The calendar spread may be utilized for trying to gain advantage of the difference which occurs owing to implied volatilities in between two different options of each month. An investor will generally adopt this technique when the options one is purchasing have a noticeably lower kind of implied volatility in comparison to the options one is selling or writing.

Calendar Spread – Characteristics

In the characteristic adaptation of this technique, a surge in the entire implied volatility in respect of options of a market at the time of the trade will have a tendency to move strongly in favour of the trader and lowering in implied volatility will be disadvantageous for the trader. In case the investor instead purchases a near month’s options in few underlying stock and sells the same underlying stock’s further out-of-the money options of the identical strike price, this is called as the reverse calendar spread. This technique will be advantageous when a fall in the entire implied volatility in respect of market’s options with passage of time.

Calendar Spread – Techniques

There is another technique which is called neutral calendar spread technique which is adopted by purchasing long term calls and at the same time selling or writing an identical number of nearby month little bit out-of-the –money or at-the-money calls in respect of the identical underlying asset having the identical strike price. When an option trader applies the technique of selling one nearby month at-the-money call and buying one long term at-the-money call becomes neutral in respect of the underlying stock for a short period of time and sells the nearby month calls to earn profit from the quick time decay. However, the profit which can be earned by the application of neutral calendar spread remains confined to the premiums obtained by selling or writing the nearby month options and the amount for time decay for the longer time options is being deducted from the premium amount received. The maximum amount of loss for adopting the neutral calendar spread remains confined to the initial premium paid for taking the position on the spread. It happens while the stock price falls and remains at the lower band till the expiry of the option in respect of longer term. An illustration for neutral calendar spread is followed here.

In the month of May, and options trader thinks that ABC stock trading at $50 will be trading in range bound manner in the next trading sessions of coming few months. He opts for the neutral calendar spread by purchasing a Sept 50 call for $450 and sells or writing a June 50 call for $250. The net amount needed to go for the spread is the premium difference of $200 debit. As speculated by the trader, ABC stock price reached the level of $50 on the date of expiration for the short term call and the June 50 call becomes worthless. The Sept 50 call lost some of its value owing to time decay however is worth $350 still and by selling this call, the trader managed to pocket $150 after considering the initial debit of $200 paid by him. In case the price of ABC stock had declined instead to $47 and remained at $47 till the expiration date in the month of September, the trader had to bear a loss of $200 which was his total investment for the trade.

Similar to all calendar spread techniques, it is imperative to take decision on which follow-up strategy to adopt while nearby term options expire. This decision relies largely on the back drop of the outlook for the underlying during that time. If the trader thinks that the implied volatility has a chance to enhance significantly, the trader may plan to remain invested up to the long term call to earn profit from type of big surge in price movement which may happen. On the other hand, if the trader thinks that underlying implied volatility will stay at lower level, then he or she may opt for another neutral calendar spread by selling or writing another nearby term call. However, it the trader is not sure about the movement of the underlying, it will be suitable for him or her to book profit or loss according to market scenario and contemplating for other trading opportunities.

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