DEFINITION:
A calendar spread is a strategy where an investor buys and sells derivative contracts simultaneously. These contracts have the same strike price but different expiration dates.
Using a calendar spread strategy means purchasing and selling the same kind of option or futures contract at the same time. These contracts share an identical strike price but have varying expiration dates.
Traders aiming for gains with limited risk in situations where they expect a neutral or directional movement in stock prices often rely on a calendar spread strategy. This approach is commonly applied in trading options and futures contracts.
Let's consider an investor named Steve who expects ABC Company's stock to either remain steady or possibly increase slowly. To capitalize on this expectation, he opts for a strategy involving options contracts known as a calendar spread.
ABC Company's stock is currently valued at ₹100 per share. Steve decides to buy a call option that lasts for six months and has a strike price of ₹103. Simultaneously, he sells a different call option with the same strike price of ₹103, but this one only lasts for two months.
Steve's potential profit is unlimited once the short-term option expires. Here's how Steve would make a profit if the stock market behaves as he expects, with a flat to slightly rising price trend:
Steve is minimizing his risk by buying a long-term call option and selling a short-term call option at the same strike price. These options react differently to changes in the security's value, helping balance potential gains and losses.
Calendar spreads work well when you anticipate the security's value to remain stable or increase slightly.
A calendar spread earns money from changes in time and implied volatility of the options or futures contract's value.
Because a calendar spread strategy involves multiple contracts—both long and short positions with different expiration dates—it's crucial to grasp how the underlying security's movement impacts the overall profit or loss of your strategy.
Let's explore three possible scenarios of price movement using the same example of Steve, the investor:
| ABC Company Price Movement | Short-Term Call Option Sale | Long-Term Call Option Purchase | Net Result |
| Increases | There is an increase in the risk of this call being exercised, and Steve only loses money if the buyer exercises the contract. | The contract value increases, and Steve profits accordingly. He has the option to sell the option for a profit, hold it and purchase additional spreads, or wait to exercise the contract for a profit. | Steve has received the premiums from selling the short-term call. He also profits from the growth in value of the long-term call position he purchased. The net result is a net gain. |
| Neutral | The short-term call would decrease in value from time decay, and the risk of the option being exercised decreases. | The long-term call may decrease in value from time decay, but at a slower rate than the short-term call. | Steve has received the premiums from selling the short-term call, and the risk associated with the short-term call being exercised decreases as it approaches the expiration date. The value of the long-term call may slightly decrease, but at a slower rate than the short-term call. Steve’s net result is either a slight net gain or a slight net loss. |
| Decreases | The short-term call would decrease in value, and the risk of being exercised decreases. | The long-term call will also decrease in value, but at a slower rate than the short-term call. | The short-term call will decrease in value, which decreases the risk of it being exercised before the expiration date. However, keep in mind that Steve has already profited from the premiums received from the sale. The long-term call also decreases in value at a slower rate. The net result may be a loss—but a smaller loss due to the profit made from the short-term call. |
If the short-term call option is exercised, then the investor may be forced to sell his long position to cover the net loss from the short-term call assignment.
The most you can lose with a calendar spread strategy is the total premium paid. However, the maximum profit is unlimited, but it's only possible after the short-term call expires.
If the short-term call gets exercised before its expiration date, it could lead to a loss larger than the gain from the long-term call option, resulting in an overall net loss.
Calendar spreads involve buying multiple derivative contracts (like options or futures) simultaneously to manage risk and increase potential gains. There are various calendar spread strategies worth knowing, including:
Horizontal Spreads: This calendar spread strategy involves buying derivative contracts with identical strike prices but varying expiration dates.
Diagonal Spreads: This is a calendar spread in which the derivatives purchased both have different expiration dates and different strike prices.
Using a calendar spread involves knowing about financial instruments like options and futures contracts. It's a bit complicated, so experienced investors usually try this strategy.
People use a calendar spread when they think a stock price will stay steady or slowly go up, or when they want to earn from owning short positions in a stock. Knowing about time decay and implied volatility is important for this strategy to work well. It can also help reduce risk when dealing with options.
