The calendar spread strategy

By roma, 11 January, 2021

The calendar spread is one of the most interesting option strategies.

From the moment you start to learn about options trading, you will be able to understand that their daily valuations depend on the levels of implied volatilities. This is already the case with options with the same expiration date, and even more so when we trade option with different expirations: this is the case of the calendar spread.

Definition

The calendar spread is an option strategy on the same underlying asset with identical strikes but different expiration dates. Calendar spreads can be executed either through calls or puts.

Key definitions

If we define C1 as an at-the-money call with a strike price 40 and expiration in 6 months, and C2 – ATM call with strike 40 and 1 month to expiration. So trader buys the call C1 (6 months) and sells call C2 (1 month). This strategy is "traditionally" realized with capital investment if no dividend is paid. Trader spends money to build this calendar spread. We say that trader purchased 1 month/6 months calendar spread.

Conversely, we will say that trader sells the calendar spread 1 month/6 months C1 call is sold and C2 call is bought. Same calendar spread can be constructed with puts.

In any case, it is always preferable to break down the options by leg in order to understand the risks involved.

Analysis

All other things being equal, the time value of the short-term option decreases faster than that of the long-term option, because short-term ATM option has higher gamma than option with later expiration.

We then deduce the following conclusions for the calendar spread.

When calendar spread is bought, it is beneficial for the trader if spot price of the underlying asset remains at the level of the options strike. The time value of the sold option is thus gained (trader receives theta). And trader will make profit if at the expiration of the sold option C2 the price of the underlying asset moves out of the money and option expires worthless.

Following the example with 1 month/6 months calendar spread the maximum profit is reached if the underlying price ends at 39.9 in 1 month. Thus option C2 loses all value, and the calendar buyer finds himself with a call C1 largely financed by the sale of the first one.

It the calendar spread is sold, it is beneficial for the trader if the spot price of the underlying moves with high volatility in one direction or the other as far as possible from the options strike.

Graphically, we show a long call calendar spread with strike of 40, expirations in 1 month and 6 months and 20% implied volatility.

The calendar spread strategy

But since calendar spread is executed through options with two different expiration dates, it is also important to pay attention to the volatility term structure (i.e. the spread between implied volatilities of two expirations).

Trader with a long calendar spread (long 6 month option and short 1 month option) position will make profit if implied volatility of 6 month option increases and implied volatility of 1 month option falls.