Mechanics of a Calendar Spread

Mechanics of a Calendar Spread

2010
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Making money in choppy sideways markets can be challenging for traders. Many traders resort to scalping or playing small swings within the range. Both of these strategies work but require significant effort, technical analysis skills, and can end up being commission-intensive. Calendar spreads offer an alternative method of generating profit during periods of range-bound, sideways price movement. Calendar spreads are also known as time spreads or horizontal spreads because they involve options with different expiration dates.

A long calendar spread involves buying an option with a longer-term expiration and selling an option with the same strike price and a shorter-term expiration. Calendar spreads can be constructed using either calls or puts, but both options must be the same type. Because the options have the same strike price and the long option has more time premium, the calendar spread is entered for a net debit. For the calendar spread to generate a profit, the shorter-term option must lose its time premium faster than the longer-term option. If the stock price remains relatively stable as the near term option expiration approaches, the value of the spread should increase.

Here is the profit and loss graph for a calendar spread at expiration:

The maximum possible profit for a calendar spread is limited to the premiums collected on the sale of the near-term option minus the time decay of the longer-term options. This occurs at the shared strike price at expiration.

The maximum possible loss for a calendar spread is limited to the initial debit paid to enter the spread.

The break-even values for the calendar spread vary by market conditions and are strongly influenced by changes in implied volatility. Calendar spreads are generally inexpensive to enter when volatility is low and more expensive when volatility is high.

If volatility levels rise after the trade is entered, the profit and loss graph will shift upward and the breakeven points will widen. The reason for this is that the long option will increase in price to a greater degree than the short option as a result of volatility.

If implied volatility falls after the trade is entered, the long option loses value to a greater degree than the short option. This causes a downward shift in the profit and loss graph and reduces the distance between the two breakeven points, resulting in a lower probability of profit.

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