Short Calendar Spreads



Short Calendar Spreads - Definition


Volatile options strategies that profit primarily through the difference in time decay of long term and short term options, achieved through writing longer term options and buying short term options.


Short Calendar Spreads - Introduction


Short Calendar Spreads are a group of volatile options strategies that profit when a stock breaks out to upside or downside. It is also an unique way of profiting from time decay through price breakouts and is the only group of limited profit limited risk volatile options strategies where the maximum potential profit exceeds the maximum potential loss. When you execute a Short Calendar Spread, you are essentially selling a Calendar Spread to someone betting on the stock being neutral. This tutorial shall explain what Short Calendar Spreads are, their working principles and the different types of Short Calendar Spreads.

What Are Short Calendar Spreads?


Short Calendar Spreads are options trading strategies designed to profit when a stock breaks out to upside or downside. The Short Calendar Spread does this by purchasing short term options and then writing higher premium long term options. This creates a credit spread where you receive money for putting on the position. In order to turn a profit, the underlying stock needs to move quickly to either direction in order to diminish the premium on all the options. Profit is then made on the difference between the decay of the short term options (which has a lower premium) and the long term options (which has a higher premium). If the stock remained stagnant, the short term options would decay at a higher rate than the long term options and would therefore not return a profit. The other side of the Short Calendar Spread trade is the Calendar Spread which is a neutral options strategy. Indeed, when you put on a Short Calendar Spread, you are actually selling a calendar spread to whoever it is betting on the stock being stagnant or neutral.

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Why Use Short Calendar Spreads?


Since we have a volatile outlook, why not use other more complex volatile options strategies such as the Short Condor Spread?

There are 2 main reasons why some options traders use Short Calendar Spreads:

1. No Margin Requirement At Some Brokers
Unlike other more complex credit volatile options strategies, Short Horizontal Calendar Spreads (or Horizontal Short Calendar Spreads) with both short and long term options at the same strike price may not be subject to margin at some options trading brokers.

2. Rewards Exceeds Risk
Most complex credit volatile options strategies has a higher maximum potential risk than maximum potential gain but this is not the case in most Short Calendar Spreads. Most Short Calendar Spreads have a higher maximum potential profit than maximum potential loss.



Working Mechanics of Short Calendar Spreads


So, how do Short Calendar Spreads work? What is the underlying mechanic / logic that makes Short Calendar Spreads profitable?

The main working principle behind Short Calendar Spreads is the fact that options lose their extrinsic value (or time value) as they go in the money. The deeper in the money the options get, the lesser extrinsic value remains.

Short Calendar Spreads depend on the underlying stock moving quickly and significantly in either direction in order to diminish the higher extrinsic value of the longer term options. This is unlike the traditional way of profiting from extrinsic value through time decay as short term options has a higher theta value than long term options. In options trading, theta is the options greek that governs the rate of time decay of options. Therefore, if the underlying stock remains stagnant, the short term options would lose more extrinsic value than the longer term options, returning a loss instead.

The picture below is a comparison of real theta values and prices of options on the QQQQ on 21 October 2009.

Theta Comparison for Calendar Spread


The picture above shows the June 2010 and November 2009 call options on the QQQQ across 3 strike prices. As you can see from the picture above, theta values of the November 2009 call options are more than twice the theta value of the June 2010 options. However, the June 2010 options have a lot more extrinsic value than the November 2009 options. This is why Short Calendar Spreads cannot depend on time decay for profit through difference in theta but need to depend on stock price movement to rapidly decrease the extrinsic value of the longer term options.

As you can see from the picture above, the Vega value of the June 2010 options is a lot higher than the vega value of the November 2009 options. In options trading, Vega is the options greek that governs how much the value of an option react to changes in implied volatility. Having a higher vega means that the long term options will gain in value faster than the short term options can. As such, one weakness of Short Calendar Spreads, which are short vega positions, is a rise in implied volatility. When that happens, the longer term options gain in value faster than the short term options, returning an overall loss.



Types of Short Calendar Spreads


In Options Trading, Short Calendar Spreads can be broadly classified as Horizontal Short Calendar Spreads or Diagonal Short Calendar Spreads. According to the way the options involved are lined up across an options chain.

Horizontal Short Calendar Spreads or Short Horizontal Calendar Spreads are the most common form of Short Calendar Spread where you buy a long term call or put option and then write a near term call or put option at the same strike price.

horizontal short calendar spread

As you can see from the picture above, horizontal Short Calendar Spreads are so named due to the way the options involved are lined up horizontally across an options chain.

Diagonal Short Calendar Spreads are Short Calendar Spreads whereby options of different strike prices are used as well.

diagonal short calendar spread

As you can see from the picture above, diagonal Short Calendar Spreads or Short Diagonal Calendar Spreads are so named in options trading due to the way the options involved are lined up diagonally across an options chain.


List of Short Calendar Spreads



Horizontal Short Calendar Spreads
Short Call Horizontal Calendar Spread : Short Calendar Spread using only call options on the same strike price.
Short Put Horizontal Calendar Spread : Short Calendar Spread using only Put options on the same strike price.
Short Calendar Straddle : Short Calendar Spread using BOTH Call and Put options on the same strike price.
Short Calendar Strangle : Short Calendar Spread using BOTH Call and Put options on the different strike prices.

Diagonal Short Calendar Spreads
Short Call Diagonal Calendar Spread : Short Calendar Spread using only call options on different strike prices.
Short Put Diagonal Calendar Spread : Short Calendar Spread using only put options on different strike prices.


Advantages Of Short Calendar Spreads



  • Sometimes no margin required

  • Higher maximum potential profit than loss


    Disadvantages Of Short Calendar Spreads



  • Subject to losses when implied volatility rises


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