How To Trade Calendar Spreads: Risks, Setups, Profitability

What Are Options Calendar Spreads?

An options calendar spread is a derivatives strategy that is established by entering a long and short position on the same underlying asset at the same time. The only difference is the options’ expiration dates.

Typically, someone deploying a calendar spread strategy would buy a longer-dated contract and sell a nearer-term option that has an identical strike price — a strike price is a set price that a derivative contract can be bought or sold at.

The trade’s goal is to profit from time passing and/or increased implied volatility in a directionally neutral strategy. With those goals in mind, the strike price should be as close as possible to the price of the underlying stock.

The trade benefits from how near and long-dated options act as time and volatility advance. If volatility increases it has a positive effect on this strategy because longer-term options are much more sensitive to volatility changes. There’s one caveat: the two options will likely trade at different implied volatilities.

Time passing also has a positive effect on this strategy, but it’s more limited and only at the beginning of the trade until the short-term option expires. Once that happens, the strategy is simplified to a long call only, with a value that will continue to erode as time passes. 

In a nutshell, the calendar spread strategy allows traders to buy a longer-dated contract and sell a shorted-dated one, allowing them to create a trade that minimizes the effects of time versus holding a long option (call/put) only.

Calendar spreads are most profitable when the underlying stock remains fairly constant and doesn’t make any drastic moves in either direction until after the expiration of the near-month option.

Calendar spreads can also be called time spreads, horizontal spreads, inter-delivery or intra-market.

Why Trade Calendar Spreads 

The major benefit of calendar spreads is they are an excellent way to fuse the benefits of spreads and directional options trades within the same position. Depending on how you implement the strategy, you can assume that either:

1. A market-neutral position that’s used a few times to pay for the spread while also taking advantage of the decay of time.
2. A short-term market-neutral position with a longer-term directional bias armed with the potential for unlimited gain.

No matter which of the above occurs, the trade can provide benefits that traditional calls or puts simply can’t.

If a trader does the opposite of a calendar spread and buys a short-term option and sells a long-term option on the same underlying security, it’s known as a reverse calendar spread.  

There are some calendar spread training tips to keep in mind, including:

• Pick expiration months as for a covered call —You should consider your calendar spread strategy like a covered call, with one difference — the investor doesn’t own the underlying stock, but does own the right to buy it. When you treat this trade as a covered call, you can quickly and easily choose the expiration months. As you select the long-term option’s expiration date, it’s advised to go at least two to three months out. But, when choosing the short strike, it’s best to sell the shortest dated option because these values decay the quickest and can be rolled out weekly/monthly (or even faster) over the trade’s lifetime.
• Leg in — Traders who own calls or puts against a stock can sell an option against the position and “leg” into a calendar spread anytime. Say a trader owns calls on a certain stock and it’s made a substantial move up but has recently leveled out, they can sell a call on the same stock as long as they’re neutral over the short-term. This strategy is great to allow traders to ride out the dips in upward trending stocks.
• Managing risk — Our last suggestion is to plan to manage risk. By this, we mean that traders could plan their position sizes around the maximum trade loss and attempt to cut losses short as soon as they deem that the trade no longer falls within their forecast’s scope.

> How To Analyze Covered Calls

What Is The Purpose Of A Calendar Spread?

A calendar spread’s purpose is to take advantage of expected fluctuations in volatility and time decay while simultaneously reducing the effect of movements in the underlying security.

The underlying stock reaching or nearly reaching the nearest strike price at expiration and taking advantage of near time decay is the goal of a long call calendar spread. Depending on where the stock is in relation to the strike price, the forecast can be neutral, bullish or bearish.

> How To Calculate Covered Call Returns

Call Calendar Spreads

A call calendar spread is one of the most popular calendar spreads. It can be applied by buying a longer-term call option while selling a shorter-term call option that’s at-the-money or slightly out-of-the-money simultaneously. The two options have the same strike price.

The purpose of a call calendar spread is to sell time, with the options trader hoping the price of the underlying stays the same when near month options expire so that they expire without any value.

On the other hand, since near-month options decay a lot faster than longer-term options, the long-term options keep their value. This allows the options trader to decide between owning the longer-term calls for less or writing more calls and repeating the process.

A rule of thumb is to own long calls with at least 45-60 days of time to expiration, before time-decay (theta) accelerates.

Maximum Profit

Maximum profit is realized when the stock price is the same as the call price on the short call’s expiration date.

This is the aim of maximum profit because the long call has maximum time value when the stock price is the same as the strike price.  

Maximum Risk

A long calendar spread with a call’s maximum risk is equal to the spread’s cost, including all commissions.

If the stock price starts sharply moving away from the strike price, the difference between the calls will approach zero and the full amount that was paid for the spread is lost.

Say the stock price falls dramatically and then the price of both calls approach zero for a net difference of zero. If the price of the stock starts to rally sharply, sending both calls into deep-in-the-money, the prices of both calls will become equal for a net difference of zero.

> How To Trade Covered Calls In Down Markets

Put Calendar Spreads

A put calendar is another options strategy involving the sale of a short-term put contract and the purchase of another put that has a later expiration date. For example, say an investor buys a put option with 60 days or more until it expires and they simultaneously sell a put option at the same strike price with 15-30 days or less until it expires.

Put calendars are used when the near-term outlook turns neutral or bullish and the long-term outlook is bearish. To turn a profit, the investor needs the underlying price to trade sideways or higher over the remaining time on the put that they sold before the remaining time on the put they purchased expires. Put calendars require paying a premium to start the position.

Put calendars also benefit from time decay since the options have the same strike price and there’s no intrinsic value to worry about capturing.

So, when investors are seeking to take advantage of the value of time, the most significant risk is the option getting deep in or out of the money, and therefore the time value disappearing quickly.

Throughout the short-term option’s life, its potential profit is limited to the extent the short-term option drops in value faster than the long-term option. However, when the short-term option expires, the strategy evolves into a long put with substantial potential profit opportunity as the potential loss becomes limited to the premium the investor paid to initiate the position.

Increases in implied volatility (IV) have positive effects on the put calendar spread strategies. Typically, long-term options are more sensitive to changes in market volatility. However, it’s important to remember that both short and long-term options can trade at different implied volatility levels — and they probably will. 

How Does A Calendar Spread Make Money?

Calendar trades generally make money when the extrinsic value on the option sold decays at a faster rate than the extrinsic value of the option bought. Here’s an example:

You’re a trader and you believe the market will continue to be quiet and stable after an option’s September expiration because it’s not an election year or there are no other signs of forthcoming market volatility.

Instead, you believe the market will rally tremendously when the option expires. So, you could simply buy a December call. But, the call premium will be expensive because of the amount of time left in the option in question. So, you could sell a shorter-term call at the same strike price to offset some of the premium — that’s called buying the calendar spread. 

Do Calendar Spreads Work?

Yes, calendar spreads can be an excellent way to fuse the benefits of spreads and directional options trades that are in the same position.

Long calendar spreads are good strategies to use when traders anticipate the price will be near the strike price at the front-month option’s date of expiration. 

Are Calendar Spreads Profitable?

Yes. Calendar spreads are most profitable when the underlying asset doesn’t make any dramatic moves up or down until the expiration of the near-month option. 

Are Calendar Spreads Limited Risk?

Yes, especially long calendar spreads with calls compared to short calendar spreads, which are strategies that profit from low volatility in the underlying stock.

On the other hand, long calendar spreads don’t require as much capital, they have limited risk and they also have a smaller potential for limited profit.

Another example of how calendar spreads feature limited risk is when a short call is assigned and the stock is sold and a short stock position is created. In long calendar spreads with calls, this leads to a two-part position composed of short stock and long call. This position in particular has limited risk on the upside in addition to significant profit potential on the downside.

If a trader is bearish, he will maintain his position hoping that the forecast will come to fruition and he will earn a profit. If the short stock position is unwanted, it must be closed by exercising the call or buying to close the borrowed stock and selling the call.

Just because calendar spreads may incur limited risk doesn’t mean they are entirely without risk. It’s important to know the following risks of calendar investing:

• Limited upside early on — Calendar trading has a very limited upside when both legs are at play. But, once the short option reaches expiration, the remaining long position gains unlimited profit potential. It is a natural trading strategy when it’s in its early stages. If the stock begins to move more than expected, this can lead to limited gains.
• Expiration dates —You have to be aware of expiration dates with calendar trading. As the short-term option’s expiration date approaches, you have to take action. If it expires out-of-the-money, the contract will expire without value. If the option is in-the-money, you’ll want to consider buying back the option at market price. Once you take action with the short-term option, you can decide whether or not to roll the position.
• Untimely entry — It’s essential to avoid untimely entry when trading calendar spreads. Ill-timed trades can lead to maximum losses swiftly. A smart trader will survey the market’s overall condition to ensure they trade in the same direction as the underlying trend of the stock.

Do You Need Margin For Calendar Spreads?

Although calendar spreads are bought in a margin account, there is no margin requirement because, in theory, the purchase option has a longer life than the written one. But, the risk is still 100 percent of the capital you commit.

So, it’s important to place careful consideration into which strategy you choose to deploy and how much capital you want to place at risk and potentially lose if your market forecast isn’t realized.

If margins are charged in calendar spreads, they feature as one-sided margin for the position the investor takes (+) Calendar Spread charge — this is charged because the price moves across months don’t show a perfect correlation.

What Is A Diagonal Calendar Spread?

When calendar spreads have different strike prices, they’re known as diagonal spreads. This options strategy takes place by entering into a long and short position in two options of the same kind at the same time: 

• Two call options; or
• Two put options 

The strategy got its name because of how it combines a horizontal spread (which involves different expiration dates) and a vertical spread (which involves different strike prices).  

The difference between regular calendar spreads and diagonal calendar spreads is that in the diagonal spread, the two options have different strike prices and different expiration dates. The strategy behind diagonal calendar spreads can lean bullish or bearish.

The strategy got its name based on how it combines a calendar spread (also known as horizontal spread), with different expiration dates and a vertical spread with different strike prices.

The terms for the different types of spreads — horizontal, vertical and diagonal — refer to each option’s position on an options grid. 

• Vertical Spread Strategies — These options have different strike price but the same expiration dates. 
• Horizontal Spread Strategy  — These options use the same strike prices, but different expiration dates and thus are arranged horizontally on the calendar. 

In the diagonal spread, the options are arranged diagonally because of their different strike prices and expiration dates.

Most diagonal spreads are long spreads with one sole requirement for the holder to buy the option with the longer expiration date and sell the shorter-term option. Naturally, the opposite also rings true and is required — for short spreads, the holder must buy the shorter expiration and sell the longer one.

What Is A Bull Calendar Spread?

A bull calendar spread is used when traders try to profit from an expected increase in the price of the underlying asset.

Bull spreads can be created by using puts and calls at different strike prices. In this strategy, call options at a lower price are purchased and call options at a higher price but with the same expiration date are sold.

If puts are used to create a bull calendar, a short put is sold at a higher strike price to a long put. When the expiration dates are the same, this is called a bull put spread. When they differ, a put calendar bull spread is formed.

What Is A Bear Calendar Spread?

The bear spread is the opposite of the bull spread and is made up conventionally of two options: long put and short put. Traders deploy this strategy when they believe the long-term forecast for the underlying asset is bearish or heading for a decline.

A bear put calendar spread is a fairly versatile strategy that’s constructed by selling a short-term put option and buying a long-term put, which leads to a net debit.

It’s technically possible to also create a bear calendar using calls. To do so, a call option is sold at a lower strike price than another call option is bought. If both options are in the same month, this forms a bear call spread. When the calls are placed in different months, a call calendar bear spread is formed. Generally, this is avoided because the short call is placed further out in time, and therefore creates much higher margin requirements – because when the long call expires, the remaining short call is naked, and therefore exposes the trader to unlimited theoretical risk potential.

Here are a few things to keep in mind when trading this strategy:

• Generates more time as time decays
• The risk is limited to the net debit
• Benefits from increased volatility 

To learn more about how this strategy can work in your favor or information and tips on any other investing strategies, get started here >

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