Thursday, November 29, 2012

The Calendar Spread Options Strategy - What Is It? How Do I Profit From Its Use?

Calendar spreads are one of the key non-directional strategies used by options traders to make money in any market. They are used in low volatility environments when a stock is not expected to move much in the next month or so (depending on the length of the trade) and/or when its options' implied volatility is expected to rise.

What are they?

A calendar spread involves the purchase of an option in one month and the simultaneous sale of an option at the same strike price in an earlier month, for a debit.

For example, let's say IBM is $200 on 1 February. We could purchase the April 200 call for $4.00 and sell the March 200 call for $3.00; a net debit of $1.00

Why would we do this?

The time decay on short term options should (usually, if the near the money) be higher than long term ones. Therefore we expect the March option in the above example to decay more quickly, widening the gap between it and the April options' values; and thus the value of the position.

For example lets say that IBM is still $200 on 28 February. The March call would be valued at around $1.75, all things being equal; the April call at $3.00. Hence the spread rises to $1.25. This is due to the March call falling by 42%, but the longer term April call only falling by 25%.

What are the risks?

The main risk is that the underlying stock moves too far up or down.

Notice that in the above examples we assumed the stock stays at-the-money at $200. And indeed calendar spreads are very profitable if they stay at the money.

Unfortunately the world isn't like that, and so let's look at the example above should IBM move to, say, $220 on 28 February.

Well our call options would both fall in value. The April one to $1.50 (rather than $3 in our at the money example). And the March one to $0.75 (rather than $1.75). Hence the calendar spread is now $0.75, a loss on our $1.00 original investment. The same effect works if the stock falls to, say, $180. A loss would ensue.

The reason for this is time value in options falls as a stock moves further away from the money. Hence any difference in time decay in absolute terms (and hence the value of the calendar spread) falls the further away from at the money the stock moves.

Why else would we do this?

The more subtle reason is volatility.

If we assume in the above example that implied volatility rises just after the original purchase; from around 15% to 25%, say. What would happen to our calendar spread?

Well, the April 200 call, originally $4.00, would rise to $5.50. And the March call from $3.00 to $4.00. Hence our calendar spread would rise from $1 to $1.50.

Therefore, one reason we would put on a calendar spread is if we believe implied volatility will rise.

The risk is, of course, that it falls.

Conclusion

Calendar spreads are a great way of profiting in low volatility 'boring' markets.

In future articles we will consider possible adjustments should the trade not go our way, and variations such as directional and double calendar spreads.

3 comments:

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  2. Great post. Calendar spreads are a popular low risk, high profit potential. You might be interested in this calendar spread video I found on Australian Investment Education, along with other option strategies http://australianinvestmenteducation.com.au/option-strategies/calendar-spread/

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