The Calendar Option Spread

A calendar spread refers to an option spread trade that specifically involves purchasing the options of an underlying market that is going to expire in a given (and distant) month. It also involves the sale of other futures or options of the same underlying market, at the same strike price, that are set to expire in a near month.

A calendar spread, also called a time spread, is a strategy used by some savvy investors who hope to take advantage of the differences in volatilities between two different months. It makes sense that the investor would try and use this strategy whenever the options he is buying have a lower implied volatility than anything he is planning to sell.

The term calendar spreads usually refers to a family of spreads involving options that have the same striking prices, stock and other details, but different expiration months. They can be made with all calls (buys) or puts (sells). If one were to use calls, then the strategy would involve buying long-term calls and then, at the same time, writing an equal number of near-month ATM or OTM calls of the same product, at the same price.

The basic idea here is to sell time. The trader is hoping that the price of the stock doesn't change much by the expiration date. Since time decay occurs faster for near month options than those other long-term options, the near term options lose their value faster while the far term options manage to retain close to the same value. At expiration, if the near term options are going to expire worthless, the trader can choose to hold onto the long-term calls, or write more calls and do everything again.

Basically the option trader was the near term options to lose value as quick as possible while the long dated options retain as much of their value. The calendar spread is a debit trade and thus needs to be exited. The trader cannot just let the calendar trade expire.

The maximum a trader can lose is the cost of the trade - the debit. The maximum the trader can make in a calendar spread is close to 100% of the debit. While 100% returns are possible, they are rare. 20-30% returns are more common when a calendar spreads works properly.

When the calendar does not work properly and the underlying stock does not behave, the trade needs to be adjusted. There are several adjustments that can be made including turning the trade into a double calendar or even a triple calendar.

Other types of calendar spreads include bull calendar spreads (riding the long call for free), the neutral calendar spread (earning from time decay) and put calendar spread (using put options instead of calls).

As always, whenever you decide it's time to invest in another opportunity, analyze your expectations (for the underlying asset or product) as well as the market. Depending on your findings and strategies, you can plan ahead for your next move. This conservative strategy may prove to be effective for you as you continue to climb the ladder of success.