The Calendar Spreads Options Strategy
What is a Calendar Spread?
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.
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 calendar spread.
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, $180 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, $220. 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.
Profit and Loss diagram
Therefore the profit and loss diagram, measured at the expiry date of the short option is:
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.
Calendar spreads are a great way of profiting in low volatility ‘boring’ markets.
In Part 2 we will consider possible adjustments should the trade not go our way, and variations such as directional and double calendar spreads.
Calendar Spread Trade Management
Recap of Part 1
A calendar spread involves selling a near term option and buying as longer dated one of the same type (call/put) and strike price (usually at the money).
We’d consider putting one on when:
We don’t expect the underlying to move much
Implied volatility is low (compared to historical averages).
Let’s revisit the example from Part 1:
…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.
We then went on to explain that we want IBM to stay close to $200 until expiration. The short March option suffers greater time decay than the long April call and therefore the spread, all other things being equal, rises in value.
We also explained that if IBM were to move too much then this difference in time decay would fall, and therefore the spread would fall. There’s therefore a break even point above and below the spread (ie $200); let’s say for simplicity’s sake $195 and $205.
If IBM expires between these points then a profit is made; a loss is made should IBM be less than $195 and more than $205.
In the perfect world IBM would sit between $195 and $205 for the length of the trade. Unfortunately this often doesn’t happen; there’s a significant risk that at some stage IBM hits the break even points. How do we respond?
One of options’ great powers is their flexibility, and the ability to adjust a trade if it doesn’t behave as planned.
So let’s say IBM is at $205. Here are the adjusting options:
Sell the calendar and take the loss.
This is always an option, but doesn’t use the opportunity to adjust the trade back to profitability.
Sell the calendar and buy a similar one at $205.
This still has the advantage of simplicity, and would be reasonably cheap if the move was early on in the trade.
However there would be a cost; the $205 calendar, being at the money, would be more expensive than the out of the money $200 spread. There would also be significant commission costs: the adjustment involves four options.
Buy another calendar at $205
This would result in what is known as a Double Calendar, a more advanced strategy we’ll cover in a later lesson. However, in summary, it comprises two calendars of the same type but at different strikes; in this case a March/April $200 call calendar and a March/April $205 call calendar.
Here’s the profit and loss graph (often referred to as a ‘tent’):
Notice how the break even points are wider, such that the stock at $205 is now within the profit zone.
The disadvantage is that the adjustment doubles the capital requirement and risk. Plus it only extends the breakeven point a slight amount above the current $205 stock price.
Buy another calendar at $210
The last of these two disadvantages can be removed by buying the second calendar above the current price; in this case at $210.
Now the profit range is pretty large: from around $195 to $215, with the stock in the centre of this range. The problem of doubling our investment in the trade remains.
Trade these spreads using a version of this last adjustment method.
Our approach is to only use half our proposed investment to buy the original (ie $200) calendar. And then the other half is used to buy the adjusting calendar above the breakeven (so that the price at adjustment is in the middle of the ‘tent’) as above (ie at $210).
Therefore the capital required for the trade plus potential adjustment is only the capital allocated to the trade, not double.
The disadvantage, of course, is the profit foregone on the first calendar should the underlying never hit a breakeven. Only half our investment has been employed and hence we receive only half the profit.
We believe this is a reasonable trade off for the additional security of putting on the double calendar without having to use too much capital.
Now that we’ve covered what a calendar spread is, how we put one on and how we adjust we’ll will expand on the approach and and the calendar spread idea.
Calendar Spread Extensions
Let’s expand on the calendar spread approach.
We’re going to look at the double calendar strategy, introduce directional Calendar Spreads and then put it together with Epsilon Options’ approach to SPY calendar spreads (mentioned briefly above).
As their name suggests these comprise two calendar spreads placed either side of at the money. For example, with AAPL at $430:
Buy AAPL April 410 Put Sell AAPL Mar 410 Put
Buy AAPL April 450 Call
Sell AAPL Mar 450 Call
(It is traditional, but not necessary, that the lower calendar are puts and the higher calendar call, but it doesn’t matter).The P&L is below (with, in our example, A=$410, By=$450):
Our approach thus far is to use the calendar, and its cousin the double calendar, as a non-directional trading tool. We want the stock to stay where it is, with the possible bonus of an increase in implied volatility.
But Calendars can also be used to bet on direction. Let’s say we thought Google would rise to $860 from its current $830 price. You could put a calendar centered on $860 quite cheaply and then wait for the move to occur; the calendar would then be higher as it would be at the money.
A favorite approach is the put version of this. Say you thought the market was going to fall from its current SPY=150 level. A Put Calendar centered at 145 would be cheap (it’s well out of the money) but would increase in value in any market fall due to both the calendar becoming more in the money, and the usual increase in volatility when a market falls. This is often used as a cheaper hedge against long positions than a straight put option.
So how do we use calendars? Well, we put together much of the above using SPY is our vehicle of choice.
SPY is the ticker for the Exchange Traded Fund (ETF) that follows the S&P 500. It’s an
excellent vehicle for non-directional trades as it is liquid, has options in $1 increments and, as
an index, isn’t prone to massive jumps from
We approach Calendars in the following way:
We allocate half our allotted capital to open the trade
- We sell the next month’s at the money options 30-40 days before expiry and buy the next months, to form a calendar spread
- We calculate the break even points
- Should the underlying threaten to cross either of the breakevenpoints, we put on another calendar, using the remaining half of our capital.
- This calendar is positioned out of the money by the same amount that the original calendar is now out of the money (see example) This forms a double calendar (see below).
.Exit is when any of the following conditions are met:
-The underlying threatens one of the breakevens of the double -The are 10 days or less left on the short option
-20% profit has been made on the trade
Let’s look at an example using SPY as the underlying:
- Let’s suppose we have allocated $1,000 to the trade Lets suppose
- SPY is at 150 on 25 February.
- We put on the following trade:
– Buy 5 SPY April 150 Calls @ $3 Sell 5 –
SPY Mar 150 Calls @ $2 Total cost: $500
The P&L graph looks like (with A=150):
Breakevens are calculated at 147 and 153 (say)
On 5 March SPY is 153 and an adjustment needs to be made.
The original spread is now 3 points away from at the money. As per our rules we add an 3 points out of the money calendar using (most of) our
remaining $500. Ie the following trade is made:
Buy 5 SPY April 156 Calls @ $2
Sell 5 SPY Mar 156 Calls @ $1.20
Total cost: $400
The new P&L (with A=150, B=156) is therefore:
The position is exited when any of the following occurs:
- SPY threatens one of the new breakevens (approx. 174 or 179)
- The sold options have 10 days left until expiry
- The position gains or loses 20%
Calendar Spreads: Trade Plan
Let’s put everything we’ve learnt together and set out the full game plan for trading calendar spreads, the Epsilon Options way…
Step 1: Choose Your Underlying
Index ‘stocks’ are perfect for calendar spreads.
They’re not volatile – they don’t crash down like stocks for example – and options over them are liquid.
We’ll choose SPY, the subject of our case study.
Step 2: Buy Calendar With Half Your Cash
Decide on your budget and allocate half of it to the initial trade.
Around 20-30 days from expiration sell the next at the money SPY monthly call option. And simultaneously buy the next monthly SPY call of the same strike price.
Let’s look at an example:
Let’s say it’s 1 June and SPY is at 175. And that you have around $3000 allocated to the trade (OK if you have less: mini options are available on SPY for smaller amounts).
Sell a 175 June SPY call and buy a July 175 call at the same time. The total price should be around $1.50.
The net cash cost of this trade should be half your trade allocation: $1500.
Step 3: Calculate Break Even Points
The lower break even point is the point at which SPY would need to fall for the trade to lose money at expiry.
It is calculated:
Lower Break Even = Strike Price Of Calls – Calendar Spread Price (In our example 175-1.50= 173.5)
The upper break even point is the point at which SPY would need to rise for the trade to lose money at expiry.
It is calculated:
Upper Break Even = Strike Price Of Calls + Calendar Spread Price (In our example 175+1.50= 176.5)
Step 4: Monitor And Close Or Adjust
Monitor the trade. If SPY stays within the break even point and the calendar spread rises by 20% (ie from 1.50 to 1.80 in our example) remove and take your profits.
If SPY hits either break even (ie 173.5 or 176.5) adjust (see below).
Step 5: Adjust if underlying hits breakeven point
Use the other half of your starting capital to buy another calendar (of the same call/put type and size as the original calendar). This should be centred so that the combined spread – a double calendar – is centred at the current stock proce.
So, in our example above, if SPY hits 176.5, say, we would buy a 178 call calendar spread to form a double calendar (with ‘peaks’ at 175 and 178) centred around 176.5.
The position is exited when any of the follow occurs:
SPY threatens one of the new breakevens (approx. 174 or 179)
The sold options have 10 days left until expiry
The position gains or loses 20%