A calendar spread is an investment strategy for derivative contracts in which the investor buys and sells a derivative contract at the same time and same strike price, but for slightly different expiration dates.
There are different scenarios in which investors may use a calendar spread strategy, as well as different types of calendar spreads. Here, we’ll discuss these in detail and provide examples of how a calendar spread works.
Definition and Examples of Calendar Spread
Implementing a calendar spread strategy involves buying and selling the same type of option or futures contract simultaneously, each with the same strike price but with different expiration dates.
Investors who anticipate either a neutral or a directional stock price movement and want to profit from it while limiting their risk often use a calendar spread strategy. Calendar spreads are most often used when trading options and futures contracts.
For example, Steve the investor anticipates ABC Company to have a flat to slowly rising price trend. To profit from this, he decides to purchase options contracts following a calendar spread strategy.
ABC Company is currently trading at $100 per share. Steve purchases a longer-term six-month call option with a strike price of $103, while simultaneously selling a shorter-term two-month call option with a strike price of $103.
Steve’s maximum gain is unlimited after the short-term option expires. Here’s how Steve will profit from this strategy, assuming the stock market follows his estimated price movement of a flat to slowly rising price trend:
- If ABC Company is below $103 at the expiration of the three-month option that Steve sold, then the option expires worthless and Steve profits from the premiums received.
- If ABC Company is above $100 per share (the price it was valued at the time of purchasing the long-term call option), Steve has the option to potentially sell the option for a profit, hold onto it if he thinks the underlying stock will surpass $103 before the six-month expiration date, or implement other spread strategies by selling other short-term options on the same underlying stock.
By purchasing a longer-term call option while selling a shorter-term call option at the same time and the same strike price, Steve is limiting his overall risk exposure from two options that benefit differently when the underlying security increases or decreases in value.
How Calendar Spreads Work
Calendar spreads are beneficial when the underlying security is expected to have neutral to moderately rising price trends.
A calendar spread profits from time and implied volatility of the options or futures contract value.
Because there are multiple contracts involved in a calendar spread strategy—both long and short positions at varying expiration dates—it’s important to understand how the movement of the underlying security will affect the net gain/loss of your calendar spread strategy.
Consider the three potential price-movement scenarios following the same example as discussed above with Steve the investor:
|ABC Company Price Movement||Short-Term Call Option Sale||Long-Term Call Option Purchase||Net Result|
|Increases||There is an increase in the risk of this call being exercised, and Steve only loses money if the buyer exercises the contract.||The contract value increases, and Steve profits accordingly. He has the option to sell the option for a profit, hold it and purchase additional spreads, or wait to exercise the contract for a profit.||Steve has received the premiums from selling the short-term call. He also profits from the growth in value of the long-term call position he purchased. The net result is a net gain.|
|Neutral||The short-term call would decrease in value from time decay, and the risk of the option being exercised decreases.||The long-term call may decrease in value from time decay, but at a slower rate than the short-term call.||Steve has received the premiums from selling the short-term call, and the risk associated with the short-term call being exercised decreases as it approaches the expiration date.
The value of the long-term call may slightly decrease, but at a slower rate than the short-term call. Steve’s net result is either a slight net gain or a slight net loss.
|Decreases||The short-term call would decrease in value, and the risk of being exercised decreases.||The long-term call will also decrease in value, but at a slower rate than the short-term call.||The short-term call will decrease in value, which decreases the risk of it being exercised before the expiration date. However, keep in mind that Steve has already profited from the premiums received from the sale.
The long-term call also decreases in value at a slower rate. The net result may be a loss—but a smaller loss due to the profit made from the short-term call.
If the short-term call option is exercised, then the investor may be forced to sell his long position to cover the net loss from the short-term call assignment.
The maximum loss on a calendar spread strategy is equal to the total net premium paid.The maximum gain is unlimited, but only after the short-term call expires.
If the short-term call is exercised before the expiration date, then the loss may be larger than the gain on the long-term call option position, equaling a net loss.
Types of Calendar Spreads
All calendar spreads follow the strategy of buying multiple derivative contracts (options or futures) at the same time to hedge against risk and/or maximize potential gains. However, you will often hear different calendar spread strategies that are worth taking note of. Some of these include:
- Horizontal Spreads: This is a calendar spread in which the derivative contracts purchased have the same strike prices but different expiration dates.
- Diagonal Spreads: This is a calendar spread in which the derivatives purchased both have different expiration dates and different strike prices.
What This Means for Individual Investors
Implementing a calendar spread requires a basic understanding of derivatives, such as options and futures contracts. In most cases, calendar spreads are used by more experienced investors due to the complexity of the strategy.
An investor might consider employing a calendar spread if they anticipate the price of a security to remain flat or slowly increase in value over time or if they want to profit from owning short positions in a security. Understanding time decay and implied volatility is crucial to the success of a calendar spread. It may also be used to minimize risk when trading options.
- A calendar spread is an investment strategy in which the investor buys and sells a derivative contract (an option or futures contract) for the same underlying security at the same time.
- Calendar spreads are used to profit from price volatility, time decay, and/or neutral price movements of the underlying security.
- Generally, calendar spreads are for more experienced investors who have a strong knowledge of derivative contracts.