If you’re looking for advanced options strategy ideas, the short calendar spread might catch your interest. This is a trade that combines selling a longer-term call and buying a shorter-term one at the same strike price. While time decay works for you on the sold call, it challenges the bought call. How does the short calendar spread work, and what are the potential benefits and risks? Let’s find out.
Key takeaways
- A short calendar spread with calls is an options strategy that involves selling a longer-term call and buying a shorter-term call with the same strike price.
- The main reason to open a short calendar spread is to benefit from a large movement in the underlying stock price with an expected drop in implied volatility.
- Time decay will be on your side on the sold leg of the strategy, while it will work against you on the bought leg.
What Is a Short Call Calendar Spread?
It may be tricky at first, but mastering the short calendar spread can be a game-changer in your options trading strategy. This technique relies on selling one longer-term call while simultaneously buying a shorter-term call, both at the identical strike price.
Picture this: you sell a three-month $190 call and buy a one-month $190 call on Apple (AAPL), currently trading at $189.72. This move gives you a net credit, and both your potential profit and risk are capped.
To better understand what we mean, take a look at the P&L profile below (note that, since the two options have different expirations, the chart below reflects the situation on the day of the closest expiration leg):
You can notice a few things:
- Your losses will be limited to $253 at an underlying price of $190, but consider that this is an estimate based on the Black-Scholes pricing model, not necessarily the actual value considering that we’re dealing with two different expiration dates.
- You can profit from strong stock movements in either direction. If the stock drops, the value of your short option increases, allowing you to earn from its decrease in value. Conversely, if the stock rises significantly, the long-term short option will lose its extrinsic value, making both options (long and short) approximately equal, allowing you to keep the premium collected.
- However, it’s important to note the main risk: theta decay generally works against you, leading to losses with normal movements or if the stock remains around the strike prices.
The net credit you will receive will simply be the price of your shorted option minus that of the contract you buy.
Traders often lean towards a short calendar spread in times of expected significant price movements, such as before earnings reports, around new product launches, or following major announcements.
The real challenge? Predicting these movements correctly. If the anticipated sharp price shift doesn’t materialize, you might find yourself stuck in what some traders call “the valley of death” of options trading (from the typical shape that the P&L curve takes), where you can neither adjust your position nor take any profits.
A Short Call Spread Example
Let us try to better understand how the short calendar spread strategy unfolds with a concrete short call spread example, using Eli Lilly (LLY) as our case study. Eli Lilly, a giant in the pharmaceutical industry, often finds itself at the mercy of high volatility following significant FDA decisions on its new drugs. Imagine you’ve heard of an impending FDA verdict on an innovative LLY drug that faces no competition.
As you may guess, approval could skyrocket the stock, while rejection might tank it. Given this binary outcome, it’s clear volatility is on the horizon; the direction, however, is something very hard to predict with no specialized knowledge (and let’s face it, even if you have this knowledge, you still can’t be 100% sure).
This unpredictability provides a perfect occasion for implementing a short calendar spread. With LLY’s stock hovering around $787.02, you could do the following:
- Sell a three-month $790 call
- Buy a one-month $790 call.
In this case, here’s what your P&L would look like:
The goal here is straightforward: you want LLY’s stock price to deviate as much from $790 as possible. Direction doesn’t matter as much since the payout structure benefits both ways, even though profits are uneven (you’re looking at a short calendar spread, do not forget it). If LLY dips below $756.96, your profit peaks at $2,220. Should it surge above $832.80, you can claim a lower yet substantial gain of $1,583.
One great aspect of this strategy lies in its flexibility. We’ve said it before, and we’ll say it again: options trading is not a flexible discipline, but some strategies (such as this one) help you hedge against some unfortunate developments.
There’s no need to cling to your positions until the bitter end. Exiting the short-term leg early to pocket profits or to adjust your stance transforms this short calendar spread from a mere speculative play into a potential income-generating trade idea. This feature is especially useful in a market driven by news and events where sentiment can shift dramatically overnight (so no, we did not pick the pharmaceutical industry by accident).
Of course, you could easily replicate this short call calendar spread idea even in other sectors. For instance, before an earnings release, you could sell a call with an expiration date right after the announcement and purchase one that expires sooner. Other events you could leverage include mergers and acquisitions, product launches, regulatory decisions (as with LLY), or even significant political events (think about what you could do with this spread on SPY before the Federal Reserve’s announcement on interest rates).
When Is a Short Call Calendar Spread a Good Idea?
We threw a lot of details at you, so we’d like to state when this strategy could make sense:
- Pre-Earnings Announcements: Implementing a short call calendar spread before earnings announcements can capitalize on the likely implied volatility (IV) crush that follows these events. The anticipated market excitement and uncertainty around the earnings report can drive up option prices, benefiting the spread.
- New Product Launches: Companies often experience an increased IV before an important announcement, and the fact that IV will likely move down once the news is out will benefit your position. By utilizing a short call calendar spread, you can position yourself to benefit from this scenario.
- FDA Approvals: For pharmaceutical or biotech companies, FDA approval decisions can lead to significant stock price swings. A short call calendar spread – as we saw in our short call spread example above – allows traders to benefit from the expected spike in implied volatility associated with these critical events, irrespective of the outcome.
In broader economic conditions where the market anticipates increased stock price volatility (hence a drop in implied volatility), such as before significant economic announcements or geopolitical events, this spread can provide an advantage by leveraging rising option premiums due to heightened uncertainty. So, as an options trader, keep your eye on the news and take advantage of market conditions with this strategy. Overall, a short call calendar spread can be an effective tool to generate returns in specific market environments and events by capitalizing on time decay and volatility crush.
Balancing Profit and Risk
There are a few aspects to keep in mind about balancing profit and risk when dealing with a short calendar spread with calls. In short, this is what you can expect in terms of risk and profit:
Maximum Profit
The best-case scenario is pocketing the net credit you received after fees. This happens when the stock price swings significantly from the strike price as your long call expires. It’s like betting on a horse race but winning regardless of whether your pick finishes first or last, as long as it doesn’t end right in the middle. If the stock takes a nosedive or skyrockets, the price difference between your calls zeroes out, and you retain the initial credit as pure profit.
Maximum Risk
Now, here’s where it gets hard. Your risk hits the top if the long call ends up worthless while the short call is still in play. The worst hit comes if the stock price mirrors the strike price at the long call’s expiration, as you probably understood from our short call spread example above. At this point, the short call holds its highest value due to its remaining time value, and since your long call might expire worthless, the price gap between your two calls widens, leaving you exposed.
Uncertainty of Maximum Loss
Let us spend a few words on an aspect we mentioned earlier: it is impossible to know the exact figure for the worst-case scenario because it depends on the short call’s price, fluctuating with market volatility.
This is the reason while a typical broker or an options screener shows the potential maximum loss at the closest expiration date, for both legs. To keep your risk within a reasonable range, you may want to run the numbers according to different strike prices and expiration dates.
Beware of the Early Assignment Risk
In case you were wondering, early assignment is a real risk to consider, particularly with a short calendar spread. It’s crucial to understand that while your long call in this strategy is safe from early assignment, the short call isn’t. Short calls often get assigned early, usually the day before the ex-dividend date. Calls in the money with a time value lower than the dividend are especially at risk.
If you’re not looking to hold a short stock position and foresee early assignment, you’ve got a couple of moves to consider. One option is to close the entire spread, selling the long call and buying back the short call. Alternatively, you could buy the short call to close it, keeping the long call active.
Should early assignment hit and you find yourself with an unwanted short stock position, you face two choices. You could close it by exercising the long call, or buy shares in the market, opting to sell the long call for potentially its time value. Generally, if the short call from your short calendar spread gets assigned early and the long call has minimal time value, it’s wiser to exercise the long call, wrapping up the position and freeing your capital for new opportunities.
A Look at Time Decay
Both options buyers and sellers must take time decay into account in their trade. Now, if you consider that a short calendar spread requires both buying and selling, the impact of time erosion becomes crucial. Time erosion, or the reduction in the time value portion of an option’s total price as expiration nears, is measured by “theta” in the Black-Scholes pricing model.
Long option positions experience negative theta, meaning they lose value over time if all other market conditions remain constant (they never do, but let’s say they do for the sake of clarity). Conversely, short options benefit from positive theta, gaining value as time erodes.
In the specific case of a short calendar spread with calls, you’re shorting a call with a longer time until expiration and buying a call with a shorter time frame, both at the same strike price. When the stock price hovers near this strike price, the spread suffers from net negative theta. This means the strategy as a whole loses value due to time decay, particularly as the expiration date of the long call approaches and its value diminishes rapidly.
However, should the stock price move above or below the strike price, the scenario shifts slightly in your favor. The time value of the shorter-term long call moves down to nothing, while the longer-term short call retains some time value. This residual value decreases gradually, making the impact of time erosion on the overall strategy somewhat positive.
How Does Implied Volatility Impact Your Trade?
We mentioned the Black-Scholes model and, if you are familiar with it, you’ll know that volatility is also a key player in determining option prices. For a short calendar spread, this becomes particularly important.
Volatility measures the stock price’s fluctuation levels—basically, how much it swings. When implied volatility (IV) picks up, so do option prices. This means long options gain value, making money, while short options lose. However, when IV drops, the opposite occurs; long options decrease in value, and short options gain.
The main idea here, therefore, is that you want an IV crush to occur, as it will drive your profits for this particular strategy.
The concept of “Vega” tells us exactly how much changing volatility will impact our position’s net price. In the setup of a short calendar spread, where one call is short with more time left and another is long but closer to its expiration, the changing volatility’s effect is slightly negative, leaning towards zero. The reason? The vega of the short call is marginally higher than that of the long call, shifting the net vega into a slight negative as we get closer to the expiration of the long call.
