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Calendar Spread
Define Calendar Spread:

"A calendar spread, also known as a horizontal spread or time spread, is an options trading strategy that involves the simultaneous purchase and sale of options with the same strike price but different expiration dates."

 

Explain Calendar Spread:

Introduction

A calendar spread, also known as a horizontal spread or time spread, is an options trading strategy that involves the simultaneous purchase and sale of options with the same strike price but different expiration dates. It is a neutral to moderately bullish or bearish strategy, depending on whether the spread is constructed using call options or put options.

In a calendar spread, the options trader will typically buy the option with the longer expiration date and sell the option with the shorter expiration date. The strategy aims to profit from the difference in time decay (theta) between the two options.

The basic idea behind a calendar spread is that the longer-dated option will have a higher premium due to its longer time to expiration, while the shorter-dated option will have a lower premium. If the underlying asset's price remains relatively stable, the shorter-dated option will lose value faster due to higher time decay, while the longer-dated option will retain more of its value. As a result, the spread can profit from the difference in decay rates.

Key points about calendar spreads:

  1. Strike Price: Both options have the same strike price, meaning they will have no intrinsic value at the time of creation if the underlying asset's price is equal to the strike price.

  2. Time Decay: Time decay is the primary factor that affects a calendar spread. The strategy benefits from the faster decay of the short-term option's premium.

  3. Volatility: A significant increase in volatility can negatively impact a calendar spread's performance.

  4. Profit Potential: The maximum profit potential is achieved if the underlying asset's price is at the strike price when the shorter-dated option expires.

  5. Risk: The risk in a calendar spread is limited to the initial cost of creating the spread (the difference between the premium received from selling the near-term option and the premium paid for the longer-term option).

Traders often use calendar spreads when they expect the underlying asset's price to remain relatively stable over the short term, and they want to take advantage of the faster time decay in the short-term option while holding a longer-term position in the market.

Example

Assume that Company XYZ's stock is currently trading at $100 per share, and you expect the stock to remain relatively stable over the next few weeks. You decide to implement a calendar spread to take advantage of the time decay in options.

Step 1: Identify the options to use You choose call options, as you expect the stock to potentially rise slightly but not significantly. You look for two call options with the same strike price but different expiration dates.

  • Buy Option: Buy a call option with a longer expiration date, let's say a Call option with a strike price of $100 expiring in 3 months. The premium for this option is $5 per contract.
  • Sell Option: Simultaneously, sell a call option with a shorter expiration date, such as a Call option with a strike price of $100 expiring in 1 month. The premium for this option is $3 per contract.

Step 2: Determine the cost of the spread To calculate the cost of the calendar spread, subtract the premium received from selling the short-term option from the premium paid for buying the long-term option.

Cost of the spread = Premium of the longer-dated call - Premium of the shorter-dated call Cost of the spread = $5 (longer-dated call premium) - $3 (shorter-dated call premium) Cost of the spread = $2 per contract

Step 3: Analyze potential outcomes There are three potential scenarios at expiration:

Scenario A: The stock price remains around $100 at expiration. In this case, the shorter-dated call option will lose value faster due to time decay, while the longer-dated call option will retain more value. As a result, you can close the position before expiration and profit from the spread's time decay.

Scenario B: The stock price increases above $100 at expiration. If the stock price rises above $100, both options will have some value. The longer-dated call option will have more value due to its longer expiration, and the spread could still be profitable depending on the magnitude of the price increase.

Scenario C: The stock price decreases below $100 at expiration. If the stock price falls below $100, both options may lose value. However, since you received a premium from selling the shorter-dated call option, it can help offset some of the losses on the longer-dated call option.

Step 4: Managing the trade As the expiration date approaches, you can decide to close the position and take profits if the spread has decayed in value as expected or if you have achieved your target profit. Alternatively, if the stock price starts moving significantly in one direction, you can close the spread early to limit potential losses.

Conclusion

Remember that options trading involves risks, and it's essential to have a clear understanding of the strategy before implementing it in a live market. Additionally, commissions and fees can impact the overall profitability of the trade.

Always consider consulting with a financial advisor or experienced options trader before executing any options trading strategies.

 

Horizontal Spread

Time Spread

Reverse Calendar Spread

Call Calendar Spread

Inverse Calendar Spread

Author: Profitloss
Source: Profit loss
Posted On: Monday, 1 April, 2024