Calendar spreads 

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. 
 
IV​ ​35 ​ ​40 ​ ​45 ​ ​50 ​ ​55 
Call Value​ ​$4.02​ ​ $4.57 ​ ​ $5.12 ​ ​ $5.67​ ​ $6.22 
 
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.