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.
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.
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
|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.
|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.
|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.
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.