Calendar Spread Options Strategy Explained (Simple Guide)
How would you like to earn money when a stock price stays relatively flat over a short period of time? If so, then you should take a look at the calendar spread strategy.
When you invest in a calendar spread, you buy and sell the same type of option (either a call or a put) for the same underlying stock at identical strike prices but with different expiration dates.
Usually, you’ll sell a short-term option while purchasing a long-term option.
The idea behind the strategy is to let time decay (or theta) work in your favor. If the price of the stock doesn’t move much, you’ll make money at the expiration date of the near-term option.
In the guide, I’ll go over the calendar spread in detail and explain how you can profit from it.
What Is a Calendar Spread?
A calendar spread is a type of horizontal spread.
If you’re unfamiliar with a horizontal spread, it’s an options strategy that involves buying and selling options at the same time with different expiration dates.
For example, if you buy the Apple $190 call option that expires in two months for $10.60 while simultaneously selling the $190 call option that expires in one month for $7.60, you’ve just opened a horizontal spread.
Usually, you’ll pick strike prices that are close to the underlying stock’s current price. In the example above, you’d open that horizontal spread if Apple shares were trading at around $190 on the open market.
Time works in your favor with calendar spreads. If the price of stock stays steady, the value of the near-term call goes down in value. That’s okay, though, because you’re short that position.
The long-term option, on the other hand, won’t move as much in the near future because investors realize that there’s still plenty of time for the underlying stock to change in price.
Calendar spreads are also affected by implied volatility (IV). An increase in IV will have more of a positive impact on the long-term option than the short-term option. That’s also good news if you’re in this strategy because you make a profit when the long-term option goes up in value.
When Would You Use a Calendar Spread?
Use a calendar spread when you think the price of the stock stay close to the strike price of the near-term option at expiration.
You make money when the stock price is at or just below the strike price when the contract expires. In that case, you keep the money you earned from selling the option.
If the stock price moves significantly away from the strike price in either direction, you’ll lose money.
You could also use a calendar spread when you think a stock price will move higher or lower in the long-term but don’t think it will move much in the short-term. In that case, the sale of the near-term option offsets your investment in the long-term option, which means that you’re buying the long-term option at a cheaper price.
How Does a Calendar Spread Work?
For starters, make sure that your trading platform supports multi-leg orders. That’s because you need to place two options orders simultaneously.
Start by selling a near-term options contract at a target strike price. Then, buy a long-term options contract at the same strike price but with a later expiration date.
A couple of important points here:
- Use the same underlying stock for all the options
- Use the same strike price for all options
- Use the same quantity of options for the buy and sell orders
Once you’ve placed the order, let time do its magic. If the underlying stock price doesn’t move much, your short-term option position will increase in value. Meanwhile, the long-term option won’t move much.
The net result: you profit from time decay as you get closer to the expiration date of the short-term option.
Real Life Example Using a Calendar Spread?
Let’s say that JP Morgan Chase is trading at $110 per share. You think it’s going to stay roughly the same in the short term so you decide to open a calendar spread.
You start by selling next month’s $110 call option for $2.95. That earns you $295 because options contracts are offered in 100-share bundles ($2.95 x 100 = $295).
At the same time, you buy the $110 call option that expires in two months for $4.45. That costs you $445 ($4.45 x 100).
The cash outlay for the whole transaction is $150 ($445 – $295).
If shares of JP Morgan Chase stay below $110 at the expiration date of the near-term option, it will expire worthless. That means you keep the $295 you earned from that transaction.
However, the value of the long call option will dip a bit as well. It just won’t dip as much.
Why? Because there’s still a whole month before that contract expires. Time decay isn’t eating into the value of that option as much as it ate into the value of the near-term option.
In that scenario, the long-term option would drop modestly in value. Let’s say it fell to $3.50.
In that case, you’d close it for a loss of $95 ($445 – $350).
But remember, you earned $295 from the near-term option. That means your left with $200 ($295 – $95).
Bottom line: you turned $150 into $200. That’s a 33% return in just one month!
What Are Similar Strategies Related to Calendar Spread?
Here are strategies similar to a calendar spread:
- Bull Calendar Spread – Just like the calendar spread expect you sell near-term call options that are slightly out-of-the-money because you think the stock will go up in value.
- Bear Calendar Spread – Just like the calendar spread expect you sell near term put options that are slightly out-of-the-money because you think the stock will go down in value.
Read Also: How does the collar options strategy work?
Calendar Spread Compared to Other Options Strategies?
A calendar spread offers limited risk and possibly limited return.
It’s limited risk because the most that you can lose is the amount you invest in the strategy.
It limits your return because you won’t profit when the underlying stock moves wildly in one direction or another.
There’s a caveat to that, though. If the stock price stays the same as the near-term option expires, that option will expire worthless and you keep the money you earned from selling it.
If at that point you think the stock will move such that your long-term option will appreciate in value, you can keep it open for an unlimited profit. However, if the stock price moves in the other direction, you’ll lose money.
Advantages & Risks of Calendar Spread?
- Limited risk – Your risk with a calendar spread is limited. That’s in contrast to solo short positions which could theoretically wipe you out if the price of the underlying stock moves significantly in one direction.
- Time is on your side – As the price of the underlying security stays the same, time works in your favor. That’s because your near-term short position will increase in value as you get closer to expiration.
- Limited profit – As is the case with so many other options strategies, your profits are limited with calendar spreads. However, you can see unlimited return if you decide to “ride out” the long-term position once you close out the short-term position.
- Potential for loss – Options rely on leverage. That means you can earn a significant return in a short period of time. It also means you can lose a lot money in a short period of time. Make sure you do some practice trading with this strategy before investing money.