Understanding the Long Calendar Spread – Tips and Insights

The long calendar spread is a relatively advanced strategy for traders aiming to profit from stability. Consisting of buying a longer-term call and selling a shorter-term one at the same strike price, the call calendar spread is ideal for when you expect the stock to reach a price and then move only barely. As we tell you below, there are ways to better manage your trade (like choosing a wide IV ratio between the two options in the strategy). We’ll also add a real-life example to show you how to put theory into practice.

Key takeaways

• The long calendar spread is an option strategy where you buy a longer-term call and sell a shorter-term call with the same strike price.
• The main idea behind this strategy is that the stock price should be relatively stable between two breakeven prices, possibly closer to your strike price.
• Consider choosing two legs with a wide IV ratio to increase the probability of profiting.
• In general, the “theta” (time decay) of the short leg will be higher than that of the long leg, meaning that time will play in your favor.

What Is a Long Call Calendar Spread?

The long calendar spread (or long call calendar spread) is a strategy for traders betting on stability. It’s a play that pairs buying a “longer-term” call with selling a “shorter-term” call, both at the same strike price.

Take eBay (EBAY), for instance, trading at $52.70. If you’re convinced EBAY will stick close to this price, a call calendar spread might be your move. In this case, you may choose to do the following:

• You sell a $53 call expiring in one week
• You buy a $53 call expiring in one month.

You do not need to stick to at-the-money (ATM) options, as you should find a strike price around your estimated stock price for the duration of the “longer” and “shorter” leg. Many traders opt to buy a call option that expires several months later, but you can adjust this time frame based on your analysis.

Your P&L profile would look like this (note that, pretty much like all brokers, our options screener draws the P&L chart based on the closest expiration date between the options in your strategy):

This specific setup could lead to earning a maximum of $54.58 if EBAY parks itself at $53 by your short-term call’s expiration. But it’s not without its risks – if EBAY falls below $51.74, you’re down $52.63, and if it strides above $54.57, you’re looking at a $36.77 loss.

Note that there’s an asymmetrical risk profile here: a long calendar spread will likely result in higher losses in a bearish move compared to what would happen in a bullish move.

A Practical Example of a Long Calendar Spread

With EBAY, we already gave you an idea of how this trade works. But let’s go even more in detail with another example, focusing on Alibaba Group (BABA). Imagine BABA trading at $86.70, and you’ve got a hunch that $88 is where it’ll hover in the coming weeks.

Therefore, suppose:

• You sell an $88 call expiring in one week with high IV, benefiting from the inflated premium.
• At the same time, you buy a $88 call expiring in a month when IV (and thus, the price) is lower.

Your P&L profile would look like this:

Note that you could easily replicate this strategy even with puts, as we told you in our article on the long put calendar spread strategy. Back to our example: this play works best when BABA remains around $88. If it does, you might maximize your profit from the premium difference. This happens because time value in this case will go near to zero and the second option in your portfolio will reach its maximum value.

However, consider your risks:

• If BABA dips below $85.63, losses kick in, maxing out at $130.23 if it keeps dropping. Note that, if the stock price drops, the longer-expiration option is more expensive and loses all its value.
• You will also lose money above $90.77, but your losses will be lower (just like we saw with EBAY), being equal to $100.87. In fact, if the stock price goes up, the extrinsic value will go down, causing you to lose money.

Why did we pick $88? This is just an example, but let’s say you’ve noticed BABA’s sudden climb from the low 80s to its current price and recognized this $88 mark as a frequent battleground in its price history (just look at the price chart below to see how often BABA fought with this support/resistance threshold):

Why does this matter for a long call calendar spread? Here’s how you break it down:

• Step 1: You start by identifying a target price that seems plausible based on recent stock performance and historical resistance/support levels. For BABA, let’s say that’s the $88 mark.
• Step 2: Your strategy requires finding options with different expiration dates but a common strike price, ideally around your target. You’re looking to short an option expiring soon with a higher implied volatility (IV) and go long on an option with a lower IV but a later expiry. The rationale? High IV generally inflates the option’s price (and vice versa), so you want IV to be on your side.
• Step 3: Build your strategy away from market events that could cause big price swings, like earnings reports or product launches. In short, if the answer to the question: “Is the market expecting a large price movement in this stock?” is “Yes,” then the stock you picked is probably not the right one for a call calendar spread.

Ultimately, the long calendar spread requires a steady hand. It’s not just about picking strikes and dates; it’s about reading the market’s expectations. There are other things to consider as well (we briefly mentioned IV, and we’ll tell you more about it later), but let us first clarify once and for all when the long calendar spread is a good idea (and when it isn’t).

When Should You Opt for a Long Calendar Spread?

There are different cases in which a long calendar spread becomes the strategy of choice for options traders. We’ll say it again: this is the right strategy when you anticipate the stock to hover near the strike price. If you expect the stock to be more likely to trade between two points, then an iron condor could be the best choice. However, if you have specific reasons to expect the stock to remain around a price level, or you also want to bet on the IV change, you’re probably better off with a long calendar spread.

Let us add a few more tips to justify the call calendar spread options strategy:

• Forecast Alignment: When your market analysis or gut feeling tells you the stock will remain near the chosen strike price, that’s your green light.
• Understanding Risk: While the eyes may gleam at the thought of high percentage returns, you must tread cautiously. Calendar spreads can also lead to significant losses if the stock strays too far from the strike price. Don’t be greedy, as, with hindsight, you will always find a better strike price that could have yielded you more profits.
• Suitable for the Seasoned: If you rarely trade options, do not start with a long calendar spread. Pick something simpler instead, such as a single call option or a put option. This is because having two expiration dates to handle is twice as demanding as having just one. If things go wrong for you, it is easier to handle a long put, long call, covered call, or other simpler strategies.
• Discipline is Key: Look at the example we mentioned above. We’re talking about relatively small gains and losses. Of course, you could simply multiply the number of contracts, but this is not the point. The long calendar spread should be seen as a way to preserve capital and reduce risk exposure over time rather than a get-rich-quick scheme.
• Consider the IV: As we’ll tell you in the section below, you should keep an eye on the IV ratio (i.e., the ratio between the front-month IV and the back-month IV). Normally, longer term options have higher IV compared to shorter term ones. However, this is not always the case, and picking a trade with IV ratio above 1 may give you nice profit opportunities.

With all these points in mind, you can now see how a long call calendar spread is more about strategy than luck or guesswork. It requires careful analysis and understanding of the stock’s behavior, market expectations, and risk management.

Consider the IV Ratio

Our long calendar spread predefined scans offer a feature known as the “IV ratio,” which works as follows:

The IV ratio is calculated by dividing the Front-month-IV by the Back-month-IV. This ratio is especially valuable when you’re racing against time, with the market close approaching and numerous potential trades to evaluate.

Here’s how it breaks down:

• IV Ratio > 1: This suggests the option you’re selling (front-month) carries a higher IV, making it costlier due to market anticipation of significant movement. It’s an indicator that you’re potentially placing a bet on heightened volatility. Note that, in these cases, an IV ratio above 1 means that there will be a higher profit for this strategy, with a correspondence between high risk and high reward.
• IV Ratio < 1: Points to the bought option (back-month) having a higher IV. In these scenarios, the preference often leans towards spreads where the sold option exhibits a higher IV than the one you’re holding onto for a longer duration. Consider that the IV ratio is normally below 1, meaning that longer term options tend to have higher IV compared to shorter term ones. What you want to do here is to look for extreme ratios, as they may hint to a trading opportunity.

As a general note, keep in mind that the main reason to open any time spread (meaning calendar, diagonal, etc.) is normally related to IV. You want to profit from a change in IV, this should be clear by now. If you don’t care about IV, there are other strategies, such as credit/debit spreads or iron condors, that you may want to consider.

What does this mean for you? Prioritizing trades with a front-month option sporting a higher IV than the back-month option aligns you with prospects of benefiting from a decrease in IV disparity.

Generally, a spike in IV tends to favor the longer-term option in your spread, setting the stage for potential gains. This approach, leveraging the IV ratio, simplifies spotting optimal opportunities without drowning in data, providing a streamlined path to informed decisions in the eleventh hour.

If we go back to our previous example, we see that the BABA’s trade idea has an IV ratio of roughly 1.40, as you can see below:

This ratio indicates that the front-month option’s implied volatility is substantially higher than that of the back-month option. Let’s look into why this is significant and how it can be advantageous in a trading strategy.

Firstly, an IV ratio greater than 1 means that the market anticipates higher volatility in the immediate term for BABA. This elevated front-month IV suggests potential rapid price movements, whether due to upcoming earnings reports, new product launches, or significant market events affecting the company. For traders, this scenario presents an opportunity to capitalize on these short-term movements, particularly if they are equipped with strategies designed to benefit from volatility spikes.

When implementing a long calendar spread with an IV ratio of 1.40, the trader is essentially selling volatility premium in the front month while buying it back at a relatively cheaper rate in the back month.

This difference tends to work in the trader’s favor as the front-month option, often more susceptible to the vagaries of market sentiment, can see its premium decay faster as the anticipated events pass and market volatility normalizes. The back-month option, with its lower initial IV, stands a better chance of sustaining its value longer, providing the trader with a relatively more stable position.

Additionally, such a trading setup allows for potential benefit from the passage of time. As the front-month option nears expiration, its time value diminishes more quickly than that of the back-month option, which still has ample time before expiry. This phenomenon, known as theta decay, means that the option seller can potentially profit from the more accelerated loss of value in the sold option compared to the one held longer-term.

It’s also worthwhile to consider the role of vega in this scenario. Vega measures the sensitivity of an option’s price to changes in implied volatility. With an IV ratio of 1.40, the longer-term option in the back month typically experiences a more stable vega, making it less sensitive to IV fluctuations. Consequently, any initial volatility spike that bolstered the front-month IV might stabilize or reduce by the time the shorter-term option expires, leaving the back-month option’s premium in a beneficial state for the trader.

What Else Should You Know about Long Calendar Spreads?

Long calendar spreads with calls stand out as a possible choice for traders eyeing profits from “low volatility” in the stock market. Unlike the high-stakes game of short straddles and strangles, which demand a large investment upfront and carry unlimited risk, long calendar spreads are more wallet-friendly and cap your risk.

If the thrill of high risk isn’t your cup of tea, these spreads offer a safer route to potentially benefit from a steady market forecast. However, it’s crucial to remember that the risk isn’t zero; you’re still putting 100% of your invested capital on the line. It’s all about how much you’re willing to risk for your market outlook.