Now that we’ve worked our way through long call spreads (that series starts here), it should make a great basis for exploring another strategy, the long calendar spread. (This strategy goes by many names, from “time” spread to “horizontal” spread.) They’re a little tricky to teach, because unlike the usual P&L graph upon expiration, a calendar spread includes more than one expiration point – hence the “calendar” part of the play. Still, if you can bust out and think beyond that typical P&L-graph mindset, you’ll find that calendar spreads can be really useful for moderately active but predictable stocks during periods of relative quiet.
We’ll get into those specifics in a minute. First, the definition:
What’s a calendar spread?
A calendar spread involves SELLING a near-term (front-month) option while BUYING a longer-term (back-month) option. So, it’s like a normal spread in that it results in a net debit to your account, but it’s different in that the strikes here are the same and the expiration months are different. You’ll also keep the type of contract the same, i.e. both are calls or both are puts. To start, we’ll focus on one-month calendar spreads for simplicity, which means for theory’s sake we’re selling a 30-day option and buying the very next month out, the 60-day option.
Calendar spreads are basically a time-decay play- that is, they try to take advantage of the fact that options decay at an accelerating rate as expiration approaches. Option traders measure time decay with a Greek called theta. (To learn more about theta, check out my blog series on the subject, starting here.)
Let’s examine a long calendar example:
Stock XYZ @ 100
Buy 1 60-day (Feb) 100 call @ -3.50
Sell 1 30-day (Jan) 100 call @ +2.50
Net debit -1.00
Our hope in this example is that the underlying doesn’t budge, the sold January call expires worthless at day 30, letting us keep whatever value is left in the February call. How much is that likely to be?
The answer is 2.50, and here’s why. On day 30, the January call expires, and the February call becomes a 30-day call. If we’re 100% right and nothing else changes except time passing (and by “nothing else” I mean volatility, price etc.), at day 30 that February call should sell for the same price as the January call did, back when it was a 30-day: 2.50.
So, if everything works perfectly, we’ll sell the February call for 2.50 at day 30; offset that against the initial cost of the spread – the 1.00 debit – and you’ve made yourself 1.50 on a risk equal to the debit, or 1.00.
Keep your eye on the time value!
This all sounds wonderfully simple, doesn’t it? Well, of course in the real markets things are trickier. I want to introduce a concept here: keep your eye on the time value. That’s the sole value you can capture with a calendar spread; since the strike prices are the same for each option, their intrinsic values will always offset each other. Since there’s no intrinsic value play to be had here, the question becomes: what might cause the time value in the back-month option to go to zero, leaving you with no value to capture at the expiration of the front-month option? This can happen in two instances, when the options become way in-the-money or way out-of-the-money.
Let me explain using the graph below. Compared to options of similar expiration, ATM options tend to have the most time value – and those that go ITM or OTM tend to drop in time value.
Look at the 102.50 strike, trading at 1.35. That’s all time value right now, and at day 30 – again, all other factors holding steady – that front option will expire worthless, and we can sell the back option for 1.35. Considering we risked 1.00 to put on the trade, that’s a pretty nice return.
But here’s an interesting symmetry: if we consider a strike 2.50 in the opposite direction, going ITM, we’ll find the same amount of time value in the contract price. The 97.50 strike is trading at 3.85, which includes 2.50 of intrinsic value and 1.35 of time value. Again, not too shabby of a percentage return on our 1.00 risked.
Remember, though: calendars are a neutral play. Ultimately if we move too deep ITM or OTM, the time value will decay enough that it’s no longer worth risking 1.00 to capture it. Consider the 105 and 95 strikes above, which both have a time value of 0.70 when you remove the intrinsic value of the 95. You wouldn’t risk 1.00 to capture 0.70 at day 30, would you? The moral of the story is clear: a little movement can be good for your calendar returns, but more than a little creates a situation of diminishing returns.
What makes a good underlying for calendars? New options investors often think: hey, it’s a neutral play, so I should go for a stock that moves as little as possible, right? Fact is, that’s not the case. Stocks with super-low volatility might behave until day 30 expiration, but then you have a new problem: you were counting on selling the back option, but now there’s very little value left to sell – not enough to make it worth your initial risk. In other words, you need to find an underlying that’s volatile enough to include some time value, but predictable enough that your calendar play will (hopefully) prove itself out.
Next week I’ll delve into some characteristics for the underlying that make them good calendar-candidates, plus other tips. Until next week, then!
Regards,
Brian (OG)
[image: In Search of Lost Time by bogenfreund on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
