Calendar Spreads (Time Spreads)

A Calendar Spread, also known as a Time Spread, is an options trading strategy that involves buying and selling options with the same strike price but different expiration dates. The strategy profits from differences in time decay (Theta) and changes in implied volatility (IV).

How It Works

  1. Sell a short-term option (nearer expiration).
  2. Buy a long-term option (further expiration).

The options can be calls or puts, and the goal is to benefit from the faster time decay of the short-term option compared to the long-term option.

Profit and Loss

  1. Maximum Profit:

    • Achieved if the price of the underlying asset is near the strike price at the short-term option's expiration.
    • At this point, the short option expires worthless, and the long option retains significant time value.

  2. Maximum Loss:

    • Limited to the net debit (cost of entering the trade).

  3. Break-Even Points:

    • Not fixed, as profitability depends on the underlying price and changes in implied volatility.

Types of Calendar Spreads

  1. Neutral Calendar Spread:

    • Strike price is set close to the underlying asset's current price (at-the-money, ATM).
    • Profits when the underlying price remains stable.

  2. Bullish Calendar Spread:

    • Strike price is set above the current price (out-of-the-money, OTM).
    • Profits if the underlying moves up but stays near the strike price.

  3. Bearish Calendar Spread:

    • Strike price is set below the current price (OTM).
    • Profits if the underlying moves down but stays near the strike price.

When to Use Calendar Spreads

  1. Market View:

    • Neutral to slightly directional, expecting the underlying to stay near the strike price.

  2. Volatility Environment:

    • Enter when implied volatility is low and expected to rise.
    • Rising IV increases the value of the long-dated option.

  3. Time Horizon:

    • Typically initiated with 30–60 days to expiration on the short option.

Example of a Calendar Spread

  • Underlying Stock: Trading at $100.
  • Setup:
    1. Sell a 1-month 100callfor100 call for 2.
    2. Buy a 3-month 100callfor100 call for 5.
    • Net Debit (Cost): $3.

Scenarios:

  1. Underlying Price = $100 (near strike):

    • The short call expires worthless, leaving the long call with significant value.
    • Profit depends on the remaining value of the long call.

  2. Underlying Price = $120 (above strike):

    • The short call incurs a loss, but the long call gains value.
    • Losses are limited by the net debit paid.

  3. Underlying Price = $80 (below strike):

    • Both calls lose value, but the loss is capped at the net debit.

Advantages

  1. Low Capital Requirement: Limited risk, as the maximum loss is the net debit.
  2. Volatility Gains: Profits from an increase in implied volatility.
  3. Theta Advantage: Gains from the faster time decay of the short option.

Disadvantages

  1. Requires Precise Timing: Works best if the underlying price stays near the strike price.
  2. Sensitive to Volatility Drops: A decline in IV can reduce the long option's value.
  3. Limited Profit Potential: Maximum profit is constrained.

Adjustments for Calendar Spreads

  1. Rolling the Short Option:

    • If the underlying price moves away from the strike, roll the short option to a later expiration or different strike price.

  2. Converting to a Diagonal Spread:

    • Adjust the strike prices of the short and long options to make the position more directional.

  3. Close Early:

    • If the trade reaches 50–75% of the maximum potential profit before expiration, consider closing the position.