Let's begin with a definition: A calendar spread is a
position consisting of two options. One is bought and the other is sold. Both options are of the same type (both calls or both puts), have the same underlying and strike price, but different expiration dates. If you buy the option that expires later, then you BUY the calendar spread. When you buy the option that expires first, then you SELL the calendar spread. Many individual investors buy calendar spreads, sometimes called 'time spreads.' This is one of the most popular trading strategies in use. Yet, I have never written about calendar spreads. It's not that I disapprove of calendars, but this strategy involves something that I prefer to avoid - and that's predicting market direction. As you will see (in a later installment), to be successful as a calendar spread trader, you must make a reasonable estimate of where the underlying stock (or index) is headed between the time you buy the spread and the time the near-term option expires.
I currently buy iron condors, which are profitable when the underlying remains within a range - but that range can much wider for iron condors than for calendar spreads. Thus, there's less emphasis placed on predicting the future price of a stock.
When opening the trade, the vast majority of investors buy, rather than sell, calendar spreads. One reason is that margin rules dictate that being short a calendar spread is equivalent to be naked short the option that expires later. Some brokers don't allow their customers to adopt such a strategy - but even when they do, the margin requirement is steep.
Here's an example of buying a calendar spread: Buy 10 IBM Jan 100 calls Sell 10 IBM Dec 100 calls Note: The options do not have to expire in consecutive months. The number of months between expiration dates is immaterial; it's still a calendar spread when both options have the same strike price.
Why buy a calendar spread? How does it earn a profit? The idea behind the calendar spread is to take advantage of the fact that the near-term option decays at a faster rate than the long-term option. Thus, all else being equal, as time passes the value of the spread increases.
But, it's not quite that simple. If the rate of time decay were the only factor, this type of spread would almost always be profitable. These spreads can lose money because other factors come into play when determining the ever-changing value of a calendar spread. I'll discuss how that happens in a later installment. Our example position (purchase of 10 Jan-Dec IBM 100 call spreads) earns the highest profit when December expiration arrives and IBM is trading just under 100. Under those conditions, IBM Dec 100 calls expire worthless and the spread owner sells the Jan100 calls. Except on very rare occasions (see below), you can expect to collect more for the January calls than you originally paid for the spread. That difference is your profit.
If you have not yet exited the position, when December expiration arrives, it's time to sell the IBM Jan 100 calls. a) If IBM >100, you must buy back the Dec 100 call at the same time you sell your Jan call. In other words, you sell the calendar spread that you bought earlier.
b) If IBM <100, the December calls expire worthless and you only have to sell the January calls. WARNING: If it's 10 minutes before the market closes and the stock is anywhere near the strike price (99.00 for example), don't assume that the calls will expire worthless. It's a good idea to buy in those December calls for a few pennies, before selling the Jan calls. Some brokers won't allow you to sell the Jan options if you are still short the Dec options.
c) You are ready to sell the IBM Jan 100 calls. Several factors are in play in determining the value of those calls. The second most important factor is the volatility environment. If implied volatility (IV) is low, the market price of the IBM Jan 100 call is going to be less than when the IV is high. Note: The IV of the December call is far less important. When expiration arrives, that IV is zero - the option is worthless or worth parity (the amount by which it's in the money).
Unless you want to gamble (and I strongly advise against doing that), it's usually best to exit the position by selling those January calls and accepting the best available price. You may choose to keep the calls and hedge them by creating a new IBM call spread, but I suggest keeping things simple (especially for rookies) by selling the calls.
Before discussing additional aspects of a calendar spread, let's see how IV plays a major role in determining your final profit or loss.
Example
If IBM closes at 100 on the 3rd Friday of December, then the IBM Jan 100 call will be worth various amounts, depending on IV.
The point of this discussion is to be certain you are aware that when it comes time to close the calendar spread, the profit (or loss) may be significantly different than you anticipated when you made the opening trade. Calendar spreads earn the best profits when the stock expires very near the strike price. But, if IV is low enough, even when the stock finishes right where you had hoped, you can still lose money on the trade is the price of the Jan 100 call is less than you paid for the calendar spread. This is an unlikely occurrence, but not impossible. Price at expiration The final closing price (at expiration) of the underlying stock affects the value of the spread and is usually the primary factor in determining whether the position earns or loses money. The further away from the strike price that the stock (or index) moves, the more unfavorable it is for the calendar spread owner. That's why it's often a good idea to exit the trade before expiration arrives. Next time I'll provide examples to illustrate this point and then I'll discuss some of the 'greeks' that are important when trading calendar spreads. I want to keep the discussion as simple as possible for readers who are not yet familiar with the 'greeks.' Final Stock Price Major Factor As with most other option spreads it's often wise to exit the position prior to expiration because some risks increase as time passes. If an investor makes the decision to hold the position until the near-term option expires, the settlement price of the underlying stock, or index, plays a vital role in determining the profitability of the calendar spread. [I don't mean to imply that it's not important when the position is closed early.] The following table shows the value of the IBM Jan/Dec 100 call spread (our example from Part I) when the position is closed at the end of the day on expiration Friday. Volatility is assumed to be 45 (as good a guess as any): NOTE: When IBM is 100 or less, the December 100 call expires worthless and the value of the Jan 100 call is the value of the calendar spread. When IBM is higher than 100, the December call is in the money. For the values in the table, the assumption is made that the IBM Dec 100 call is bought at parity (the option's intrinsic value, or the amount by which it's in the money) and the IBM Jan 100 call is sold at it's value.
IBM Price 88 92 96 100 104 108 112
Dec 100 $0.00 $0.00 $0.00 $0.00 $4.00 $8.00 $12.00 Jan 100 $0.97 $1.87 $3.23 $5.08 $7.50 $10.36 $13.57
Spread $0.97 $1.87 $3.23 $5.08 $3.50 $2.36 $1.57
As you can see from the data in the bottom row, the value of the spread is highest when the stock is near the strike price and steadily decreases as the stock moves away from the strike. Thus, when trading calendar spreads, it's advantageous to have an idea where the stock price is headed. For me and my comfort zone, I prefer to avoid predicting direction. Bullish, bearish, or neutral? If you are bullish on a stock, one way to play that feeling is to buy an OTM call calendar spread. If you are correct, as the stock moves higher (towards the strike price of the spread), you not only gain as time passes, but you gain as the stock rises. Of course, if it rises too far, the spread begins to lose value. Thus, one reason to consider taking your profits early occurs if the stock moves to the strike. Similarly, when bearish, you can buy an OTM put spread. The problem with have a neutral opinion on the stock is that the calendar costs the maximum when the stock is near the strike. That makes it costly to buy a calendar spead. If you are truly neutral, buying an iron condor is probably a better choice. Calendar spreads often represent an inexpensive way to take a bullish (buy OTM call calendar spread), bearish (buy OTM put calendar spread), or neutral position (but ATM calendar spread) on a specific stock or index. When you buy such a spread, you have a position that is long vega. That means it does better (larger profit or reduced loss) when implied volatility increases during the time that you own the position, and loses money when implied volatility decreases. Thus, when buying the calendar spread, it's important to recognize when the implied volatility is at a level you are willing to pay. Currently, during the 2008 October massacre, implied volatility (as measured by VIX) is at a level that has never been seen before - except during the crash of October, 1987. I won't be buying vega at this level, but that doesn't mean you shouldn't! The bearish play offers the opportunity for higher profits than the bullish play - because IV tends to increas when the stock or index moves lower and tends to decease when the stock moves higher. To me, the opportunity for calendar spreads occurs when IV is very low (not too long ago VIX was - what seems to be an unbelieveable level: VIX was under 10 as recently as Jan 25, 2007. For comparison purposes, VIX was as high as 76.94 durng the day, last Friday (10/10/2008). When that lov VIX scenario occurs, it's very inexpensive to buy options, or make any play that includes positive vega - such as calendar spreads.