While most options strategies feature contracts with the same expiration date, calendar spread options let you “play” with the time concept. This strategy – very popular in options and futures trading – uses different expiration dates to manage volatility, generate income, and limit risk. However, it comes with its own set of challenges, including complexity and limited profit potential. What is a calendar spread? In this guide, we’ll take a look at the calendar spread definition and how you can use this calendar option strategy effectively.
Key takeaways
- The Calendar spread options strategy is a trade setup that involves buying and selling options with the same strike and different expiration dates.
- Benefits include generating income, managing volatility, and limiting risk, while drawbacks include limited profit potential and complexity.
What is a Calendar Spread?
First of all: what is a calendar spread? You can think of a calendar spread options as a 2-dimensional strategy that involves selling a near-term put or call and buying a longer-term put or call. With calendar spread options, you’re leveraging time decay and volatility. With a calendar option strategy, traders aim to profit on the differences in time decay rates between contracts with different expiration dates.
A key distinction within this group of strategies is between long and short calendar spread options. Nine times out of ten, you will find yourself evaluating a long calendar spreads, rather than a short one (we’ll explain why this is the case later in the article).
When building a long calendar spread with calls or a long calendar spread with puts, the strategy basically consists of:
- Selling a call (or a put) at a closer expiration date
- Buying a call (or a put) at a later expiration data at the same strike price
What makes calendar spread options particularly appealing is their flexibility and the ability to adjust according to market conditions. As we’ll explain later, you may choose to close the first leg of the calendar spread strategy at a profit, open a new one, and turn this into an income strategy.
Before we proceed with the rest of the things we want to tell you, take a look at the table below, where we summarize the main features of calendar spread options:
Example of a Long Calendar Spread with Calls
As always, an example can tell us more than a dozen explanations. Let’s look at a practical scenario involving long calendar spread with calls, focusing on the Disney (DIS) stock, currently trading at $121.53. Imagine you’re optimistic about DIS, expecting it not to fall in the coming weeks and to possibly edge upwards or remain stable. This outlook is a great opportunity for testing a long calendar spread with calls strategy.
Here’s how it works: using an options screener, you could find that you can sell a $123 call expiring in two weeks and buy a $123 call expiring in four weeks, just like you see below:
Note that, on Option Samurai just like on other websites, the P&L drawing is actually an estimate based on the situation at the expiration of the shorter-term leg. Therefore, it may not be an accurate representation of the actual profit and loss levels.
Essentially, consider that this strategy is a debit position where the longer-dated option is more expensive than the shorter-term one. What happens is that if the stock price increases too much, the difference in price between the short and long legs will be rather small, turning your position into a losing trade.
What about the case in which the stock price sharply decreases? Well, in this case, the longer term option are more expensive, meaning that it will lose more value compared to the short-term one.
Note that, if you end up being close to the strike price, the longer term option will virtually remain at the same value, and the short term option price will almost lose all its time value. This is why calendar spread has this P/L shape.
This reasoning does not take into account implied volatility, but you can understand the main rationale behind the strategy.
Now, let’s take a look at the historical price of DIS:
Consider Disney’s recent climb to a price near $120, after a period of trading lower. The current upward trend may suggest stability or continued growth, making a sudden bearish reversal or an excessively bullish movement less likely. If you’re right in your intuition, these market conditions make the long calendar spread with calls a nice idea to consider.
Why does this matter to you? When experts talk about portfolio diversification, they tend to recommend investing on different asset classes, industries, and so on. Option trading gives you another dimension to diversify your trades: time. If you include options with different expirations in your portfolio, you’re no longer subject to only one point in time.
You can speculate with options on how a stock will perform over the next week, next month, or quarter.
Moreover, this example shows you that there is really no point in building a calendar spread strategy without taking a look at the stock’s historical performance. The historical performance of DIS stock provides a context that may or may not support the rationale behind choosing long calendar spread options. It’s a calculated approach, banking not on dramatic shifts but on the steadiness of a well-established company’s stock.
There is also an important point to make about implied volatility (IV), but we’ll tell you more about this after we see a second example.
Example of a Long Calendar Spread with Puts
A second example of using calendar spread options in your trading strategy involves a long calendar spread with puts. Let’s revisit Disney (DIS), which is currently valued at $121.53. This time, our calendar spread strategy shifts towards a more bearish or neutral market outlook.
If you’re speculating that DIS won’t see significant upward movement in the coming weeks and might either maintain its current level or drop slightly, a long calendar spread with puts could be an intriguing option.
In this scenario, using our options screener, you might find an opportunity to sell a $119 put expiring in two weeks and buy a $119 put expiring in four weeks, as you see below:
Here, you’re betting on DIS to hover above $115.48 and stay below $123.32. Ideally, your profit maximizes if the stock’s price stays within this range. Note that while the loss potential is capped on both ends, you face a more significant risk if DIS falls below $115.48, whereas the risk diminishes if the price climbs above $123.32.
Once again, let’s look at the price chart of DIS:
The price has recently approached the $120 mark after trading considerably lower in previous months. Given this upward trajectory, predicting a sideways movement or even a slight retreat in its bullish run isn’t far-fetched. Therefore, if you believe the stock’s rally might pause, a long calendar spread with puts could align well with your market perspective.
Once again, consider the time diversification aspect. If you include options with different expirations in your portfolio, you are no longer limited to a single point in time. You can speculate on how the stock will perform over different periods, with another layer of diversity to your trades.
At this point, it is time we tell you about implied volatility and its impact on calendar spread options.
A Look at Implied Volatility (IV) Before Opening a Calendar Spread
After seeing the two examples above, we should give you a hint on how these calendar spread options were not just randomly picked. In fact, we chose them based on our predefined scans that closely examine the Implied Volatility (IV) ratio of all calendar spread options. If you include a reasoning on the IV of both legs in your calendar option strategy, you may increase your profit probability.
To build a successful calendar spread options strategy, you’ll probably want to compare the IV between the two options you’re dealing with. The general idea here is to sell options with high IV and buy those with low IV. Why? Well, under normal circumstances, you’ll noticed that an option with high IV is often overbought, while the opposite is true for those with low IV.
Our options screener gives you a feature called “IV ratio,” calculated as [Front-month-IV] / [Back-month-IV]. This ratio is really a strong tool because it helps compare the IV of both options involved in the spread without doing too much research (imagine you’re looking at dozens of potential trades and the market close is only 30 minutes away, you will probably want to have a quick way to spot the best opportunities).
A value greater than 1 indicates that the sold option has a higher IV, suggesting it’s pricier due to heightened market expectations for movement. Conversely, a ratio smaller than 1 points towards the bought option having the higher IV. Therefore, what we are saying is that you’ll often prefer those calendar spread options with an IV ratio higher than 1.
What does this mean for you? If you prioritize trades where the front-month option (the one you sell) has a higher IV compared to the back-month option (the one you buy), you’re positioning yourself to potentially benefit from a decrease in IV disparity over time.
As a final tip, note that, in general, an increase in IV will put you in a favorable scenario. By this we mean that the longer-term option will normally be more affected by the IV increase, giving you a profit on this side of the trade.
Pros and Cons of Calendar Spread Option Strategies
If you are not new to options trading, you won’t be surprised to learn that there is no such thing as a perfect strategy for everyone. What you normally read online is that you should look at your trading style to choose whether this calendar spread strategy is good or bad for you. This is a rather generic statement, so let us specify it for calendar spread options below.
Advantages
- Income Generation: If you close the shorter-term leg at a profit and your longer-term leg is still far from expiration, you can choose to reopen another short-term leg intending to replicate the trade you have just closed. Ideally, this can turn your calendar spread options into an income strategy if you think about it this way.
- Flexibility: Traders appreciate the flexibility to trade calendar spread options based on expectations of volatility and time decay. The accelerated time decay of the near-term option relative to the longer-term option can be a significant advantage. Also, there’s no rule on how far in time the longer-term leg should be, which gives you complete control over the strategy.
- Limited Risk: The maximum loss is limited to both sides of your calendar spread options. Compared to a strategy like a short strangle, for instance, this is a more risk-averse approach for someone who is not too bullish (or bearish) about the market.
- Playing with Volatility and Time: Implied Volatility (IV) is mean-reverting. This simply means that high IV is destined to go down, while low IV is doomed to move up. If you understand this simple rule, you can sell a high-IV option and buy a low-IV one when setting up this strategy, which gives you a considerable advantage over most traders.
Disadvantages
- Limited Profit Potential: As you saw in our examples on calendar spread options, the benefit of a capped risk comes with the limit of a capped profit.
- Complexity: When you include two calendar spread options with different expiration in your strategy, the complexity of your trade increases. You need to keep a constant eye on time decay and IV changes to be well-aware of what is going on.
- Cost and Execution Risks: Engaging in multiple transactions (think, for instance, to the income case we mentioned above) means more transaction costs.
- Impact of Dividends and Interest Rates: Unexpected dividends can affect equity options’ optimal strike price and profitability. Similarly, changes in interest rates can influence the cost of the options, especially the longer-term ones in the spread.
Handling Profits and Losses with Calendar Spreads
Now suppose you have an open calendar spread options position, and you’re looking to manage your profits and losses effectively.
One of the great aspects of a calendar option strategy is the limitation of maximum loss on both sides of the trade, as you saw in our examples.
It’s important to note that many websites estimate the probability of success with calendar spreads hovers around the mid-forties percent range. If you look at our scans and leverage the IV ratio, you can easily go in the 50s-60s and sometimes higher, giving you a better probability of profit.
There is no secret to success here, but you may want to do several things to increase your profit chances. For instance, you may keep the strike price of your options close to the current stock price, allowing for minor adjustments based on slight bullish or bearish inclinations.
When it comes to handling profits, seasoned traders often aim for a return of 10% to 25% of the premium paid. Many experts estimate that more than a 25% return is challenging and less common, while settling for less than a 10% return might not justify the risk and effort involved in this calendar spread strategy.
How to Manage Calendar Spread Options
So, how do you manage a calendar spread options strategy effectively? Unlike what other websites might suggest, there’s a flexible approach that can significantly enhance your strategy’s profitability.
You don’t always have to wait for the shorter-term leg of your calendar option strategy to expire. If you’re already making a profit on it, consider closing it early and opening a new leg that expires closer to—but still before—the expiration of your second leg. This method can transform a simple calendar spread strategy into a dynamic income strategy. Think about it as taking some of the profits off the table.
For instance, if you’ve set up a long calendar spread with calls or puts, and your first leg is set to expire in 2 weeks, you don’t have to stick rigidly to this timeline. Suppose the market moves in your favor, and you see profits sooner than expected.
In that case, you could close this profitable leg and open another one. If your second leg is 4 weeks away, you could theoretically repeat this process multiple times, each time cashing in on the premium collected from selling the short-term leg. For the last adjustment, you can turn calendar spreads into a debit/credit spreads to have another chance of profit.
This approach capitalizes on favorable market movements and allows for consistent income generation over time. It’s a twist on the calendar spread strategy that lets traders extract more value from their positions with a less passive approach.
A Note About Short Calendar Spreads
Before leaving you, we should explain why we only discussed the so-called long (or, better, “debit”) calendar spreads. There’s a different version, known as the short (or “credit”) calendar spread, which requires you to buy a near-term put (or call) and sell a longer-term put (or call). This approach is less popular than the long calendar spreads that we included in the article.
The result of this short calendar spread – whether you perform it with puts or calls – will look like the specular version of the strategies mentioned above:
As you can see from the picture above, your losses will reach their maximum level between your breakeven points, and your profits will be limited on both sides of the trade.
One key reason for its lesser popularity is the significant capital requirement. While it’s possible to have the long option in a near-term cycle, and the short option with a longer-term expiration date, this setup requires more buying power due to the extrinsic value risk now being in the short option.
On the other hand, buying the longer-term option and selling the shorter-term option, as seen in a long calendar spread with calls or puts, enhances capital efficiency. It doesn’t tie up a lot of your buying power, making it suitable even for individual retirement accounts (IRAs). This capital relief isn’t available if your short option spans beyond the long option’s expiration cycle.
