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Calendar Spreads

How Does Calendar Spreads Work in Options Trading?

Calendar Spreads - Definition

A type of options trading strategy that uses a combination of options with different expiration dates in order to profit primarily from time decay.

Calendar Spreads - Introduction

Calendar Spread is a term for a group of options trading strategies. It is not the name of a single options strategy as there are many different types of Calendar Spreads. Calendar Spreads have been gaining popularity recently as a way of profiting from time decay in the short term while keeping the possibility of profiting from explosive directional moves in the long term. Due to its ability to profit from time decay across multiple months, Calendar Spreads are also known as "Time Spreads". This tutorial shall cover what Calendar Spreads are, the nature and role of Calendar Spreads as well as the different categories of Calendar Spreads and a detailed listing of all Calendar Spreads. Calendar Spreads referred to here are long calendar spreads.

What Are Calendar Spreads?

Calendar Spreads are options trading strategies that makes a profit primarily through the difference in rate of time decay between options with longer expiration and options with shorter expiration. Due to this nature, Calendar Spreads are typically neutral options strategies on a month to month basis as the main source of profit is the decay of extrinsic value. Calendar Spreads typically suffers if the underlying stock stages a breakout which causes the short term options to rise in value faster than the long term options. However, the advantage that Calendar Spreads have against other neutral options strategies is that it keeps a long term options position in place which can be eventually positioned to take advantage of a longer term directional move. In general, any options trading strategies that put together options of different expiration months on a single underlying are calendar spreads.

Why Use Calendar Spreads?

Since we are neutral on a stock and aim to profit from time decay, why not just do straight forward naked call writes or naked put writes. In fact, a Short Straddle would be ideal in options trading if a stock is expected to remain stagnant in order to profit from time decay. Why Calendar Spreads?

There are 3 main reasons why some options traders use Calendar Spreads:

1. Lower or No Margin Requirement
Margin is required for a pure naked write position, thus locking up significant portions of your fund. However margin is significantly lowered or not required when there is an offsetting long options position. The long term options in Calendar Spreads provide that offsetting effect while still preserving profitability.

2. Limited Risk
All naked write options trading strategies exposes you to unlimited risk. That is, you will continue to lose money as long as the stock continues to move against your favor. However, due to having an offsetting long position in a Calendar Spread, Calendar Spreads have limited risk exposure, putting a cap on the maximum loss that can result on the position.

3. Versatility
Calendar Spreads can easily be transformed into pure long options positions when the underlying stock is expected to stage a breakout by simply closing out the short term options.

Working Mechanics of Calendar Spreads

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

The main working principle behind Calendar Spreads is the fact that options with longer expiration has lower theta than options with shorter expiration. In options trading, Theta is the options greek that governs the rate of time decay of options. The higher the theta, the higher the rate of theta. The lower the theta, the lower the rate of theta.

The picture below is a comparison of real theta values 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. This ensures that the short term options decay twice as fast than the long term options thereby returning a positive return as long as the stock does not move significantly.

Another way by which Calendar Spreads profit is through a rise in implied volatility.

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, thereby producing a positive options trading return all things equal.

Types of Calendar Spreads

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

Horizontal Calendar Spreads are the most common form of 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 calendar spread

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

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

diagonal calendar spread

As you can see from the picture above, 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 Calendar Spreads

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

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

Advantages Of Calendar Spreads

:: Little or no margin required

:: Limited Risk

:: Versatility to transform position into a long position.

Disadvantages Of Calendar Spreads

:: Lower profitability than a straight forward naked write.

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