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Strategy Overview

Calendar spreads are a great way to express a particular position without taking on undue risk.  The simplest form of a calendar spread is when a trader sells one option in the front month and then buys the same strike in a further out month.  In essence, this strategy takes advantage of Theta (time decay) while still allowing the trader to participate if they are proven correct on the direction of the move of the underlying.  By selling some premium, the breakeven point is potentially lowered and maximum loss is reduced.  A trader would use this strategy if they are mildly bullish or bearish and would like to express a hedged position or if the trade is neutral; calendar spreads are quite versatile.

Trade Setup

There are many different ways to employ calendar spreads and we will take a look at a couple of examples here.  But remember, you can be long the spread, as described above, short the spread (where you buy the front month and sell the further month), you can use calls or puts and you can also move the strikes around.  As you can imagine, there are virtually endless combinations of ways to use calendar spreads depending on your view of the underlying.

The best time to use a long calendar spread is when you are expecting a range bound trade.  This is because you are long the longer dated option.  Therefore, even though you are short another option, you don’t want the underlying to move to far in the direction of your position, as the point of the strategy is to take advantage of time decay in a hedged position.  If you are long a calendar spread, it means you are long the further month option and you are expecting to take advantage of a large move, while hedging with the short front month option to reduce potential loss if you are wrong and to pay you while you wait for the big move.  The idea is for the underlying to be range bound until front month expiration and then move with our trade after that.  Therefore, we don’t want to put on long calendar spreads with something that moves around a lot.

In terms of selecting strikes, you would want to decide whether you wanted to express a bullish, bearish or neutral position with your spread.  Based on your bias, you want to decide whether you are going to short a calendar spread or go long.  Depending on your view, you could use different combinations of short and long calendar spreads to express your position.  In addition, you’ll want to keep a close eye on implied volatility for the strikes you choose.  Ideally, you’d want to sell the higher IV option and buy the lower IV contract.  This helps you maximize Theta in your favor, increasing your odds of success.  Of course, if you sell an option that encompasses a major news event, like an earnings release, you may have the trade go against you simply for being short an option that suddenly increases its implied volatility rapidly.  This is something to keep in mind when selecting your strikes.

Trade School: Long Calendar Call Spread

In this neutral-to-bullish strategy, we are trying to express our position by selling a near-month contract while simultaneously buying a longer-dated contract with the same strike price.  This means we are selling a contract that ostensibly has a higher Theta value than the longer-dated contract we are purchasing, in order to put time decay on our side.  Of course, this trade will result in a net debit at opening because we are buying a longer-dated contract than we are selling.  In selecting strikes, you will want to choose a strike that is at least a couple of percent above (for calls) or below (for puts) the current underlying price in order to ensure you can minimize risk of loss while still participating in the upside if the trade moves with your position.

The maximum risk on this trade is only the net debit at the outset of the trade and the maximum profit is theoretically unlimited up until expiration of the long option.  Of course, you could switch this trade to puts instead of calls to express a bearish position.

To demonstrate this technique, we’ll use the S&P 500 ETF, SPY.  At the time of this writing, the SPY was trading at 145.66.  We are going to simulate this position using a short February 148 Call and a long March 148 Call.  The combination of the short February call and the long March call gives us our Long Calendar Call Spread.  Keep in mind that with the SPY trading at 145, this trade, with the strikes at 148, is expressing a slightly bullish position.

Upon opening of this trade, the P/L graph looks a little depressing, with a max profit of only 6 bucks and an enormous range of prices where you lose money.  However, the breakeven at initiation is the range of 145.84 to 150.62, so we are off to a decent start there.

Calendar Spread

As you can see on the bottom of the table, the February call is sold for 1.19 and the March call is purchased for 2.16, resulting in a net debit of 0.97 on opening.  This is also the maximum loss the trade can incur.

The point of this trade, however, is not to try and make money immediately; rather, the idea is to let the front month call expire worthless and own a longer dated call that you paid very little for.

Taking a look at the Greeks, we can see that the February call has an implied volatility (IV) of 11.52 and the March call has an IV of 12.80.  A lot of times, when putting on a long calendar spread, the front month contract will have a higher IV than the back month, but since the IVs are so low on these two options, the difference is very tiny.  Given this, we are actually net long volatility in this particular trade but given that the VIX is below 14, I don’t think that’s a bad thing.

Turning to Delta, we see that the front month option has a Delta of -36.77 and the longer option has a Delta of 41.80, which is what we would expect to see.  This gives us a net of 5.03 Delta, which, again, we would expect given the fact that we are expressing a bullish position and are long a further dated option than we are short.

Gamma for the front month option is -6.66 (reflecting that we are short) and the March option is 4.82.  This net of -1.84 Gamma means when there is a change in the price of the SPY, we are susceptible to the risk that the short option will gain Delta (and price) more quickly than the long option.  This means that we could be subject to short term losses if the SPY moves up very quickly before the February option expires.  This is a risk that must be assumed with a long calendar spread as we are inherently betting that the underlying will not move much before expiration of the front month option.  The idea is to take advantage of the move after the front month contract expires.

Theta for the February option is 2.61 (reflecting that we are short) and for the March option, it checks in a -2.34 (reflecting that we are long).  I usually like a larger net Theta than what we have here (0.27) but as I mentioned, with the VIX below 14, we can’t expect much from Theta.

Finally, Vega for this trade comes in at -17.53 for the February option and 24.08 for the March contract.  Our net Vega of 6.55 on this trade means that, again, we are susceptible to implied volatility changes.  Having a positive value means we are long volatility as an increase will raise the value of our long call more quickly than it will raise the value of the short call.  With the VIX under 14 and implied volatility for this trade even lower, I certainly want to be long volatility.

Let’s now take a look at some scenarios with different volatilities to see what happens to our trade if volatility moves up or down.

First, here is the trade, still upon opening, if volatility moves up three percent, corresponding to roughly 15 IV for these options.  As you can see, since we are long volatility in this trade, we benefit substantially.  The break even range moves all the way to 142.56 to 154.30 and maximum profit moves up from $6 to $25.

Calendar Spread +3 percent Implied Volatility

Now, here is the same trade, still upon opening, with volatility moving down three percent, corresponding to roughly 9 on these options.

Calendar Spread -3 implied volatility

As you can see, since we are still long volatility, when it decreases, we get crushed.  There is now no breakeven point as every point on the graph is below zero.  Ouch.  The maximum profit in this scenario is a loss of $10.

The lesson is that when you go to put on a long calendar spread, you must pay careful attention to all the Greeks upon opening in order to make sure you understand the risks associated with holding the position with respect to volatility and price movements of the underlying.  If you intend to hold the position to expiration no matter what happens (which can be imprudent), this won’t be quite as important but if you adjust your positions, you must be aware of what volatility and price movements will do to your position.

Now that we have seen the various ways the position can look at opening, let’s take a look at the way the trade looks on expiration day for the February call.

Here is what the trade looks like upon February expiration with volatility having remained unchanged from when the trade was opened.

Calendar Spread at expiration

What we can see here is that at front month expiration, this trade has a break even range of 145.13 to 151.04 on the SPY.  This is a pretty significant break even range given that the underlying started the trade at 145.66 and we set our strikes at 148 for each month.  In other words, the underlying doesn’t necessarily need to move up to our strikes (or at all) for us to make money on this trade.  Of course, this will vary depending on what strikes you choose but based on our parameters, this is a high percentage trade.  In addition, if the underlying trades for 148.03 upon February expiration, we can close our trade out for a profit of $113.85.  Given that we only spent $97 to put the trade on, that would represent a 117% profit on cash.  Of course, that particular price is unlikely but the graph shows we can still make solid profits on our $97 debit at a variety of prices.

Now let’s take a look at the same graph, but with volatility having moved down three percent upon February expiration, corresponding to about 9 on these options.

What we see here is that our max profit has moved all the way down to $64.80 and our break even range has shrunk to between 146.47 and 149.60 on the SPY.  Obviously, since we were long volatility in this trade, we have to expect that contracting volatility will bring about potential losses.  However, all is not lost.  We can still make money on this trade over about a three dollar range in the SPY.

Finally, let’s take a look at what happens if volatility moves up three percent by February expiration, corresponding to roughly 15 for these options.

Calendar Spread at expiration +3 implied vol

Our break even range is now absolutely huge, ranging from 143.68 to 152.64 on the SPY.  In addition, our max profit has skyrocketed to $162.90 if SPY closes at 148.03 on February expiration.  The lesson is clear; if you are going to go long a calendar spread, you need to be bullish on volatility as well or you will get run over.

 Trade School: Short Calendar Call Spread (aka Reverse Calendar)

In this bearish strategy, we are expressing our position by buying a near-month contract and selling a longer-dated option with the same strike price.  This trade will result in a net credit on open as we are selling a more costly option than we are buying.  In terms of selecting strikes for this strategy, you will want to select a strike that is no more than a couple of percent above (for calls) or below (for puts) the current underlying price in order to make sure you can sell significant premium and still minimize loss if the trade moves against you after the near-month contract expires.

The maximum risk on this trade is theoretically unlimited after the expiration of the near-month contract because after the long option expires, you are short the longer-dated option.  This provides a nice credit on opening the trade but it also exposes the trader to potentially unlimited losses if the underlying makes a big move in the direction of the position after the long call expires.

Again, we’ll use the SPY here, with the underlying trading at 145.66 upon opening of this trade.

We are selling the March 148 call for 2.16 and buying the February call for 1.21.  This results in a net credit of 0.95 upon opening the trade.  This P/L graph may look a little funky but the idea of this trade is to profit from the SPY falling.

Short Calendar Spread

As you can see, our max loss on this trade at open is only $8 and our max profit is the full $95 credit we received.  Also, the range of prices where we make money is huge, ranging from 0 to 145.55 and also 150.91 to infinity.  The range of prices between 145.55 and 150.91 is where we can see losses.

The Greeks are all same as the first trade but reversed.  I won’t go through each in detail again because it would be redundant; however, I would like to point out the differences in the way the trade will behave.  You can refer to the long calendar call spread section for detailed explanations of each.

In the first trade, we were:

  • Long Delta
  • Short Gamma
  • Positive Theta
  • Long Vega

Conversely, in this trade we are:

  • Short Delta
  • Long Gamma
  • Negative Theta
  • Short Vega

Now that we have that sorted, let’s take a look at what happens to this trade when volatility moves up three percent (to roughly 15) just after opening the trade.  Remember, we are net short volatility so this is not a desirable outcome.

Short calendar +3 implied volatility

You can see that our max profit is unchanged since we received a credit but our max loss is now $25.67 instead of $8.  In addition, our range of prices where we lose money has grown substantially, to between 142.56 and 154.30.  In other words, volatility rising three percent has significantly reduced the likelihood of us making money on this trade as we now need a sizable move in the SPY to breakeven.

Now, here is the same graph except with volatility moving down three percent at opening (to roughly 9).

Short calendar -3 implied volatility

As you can see, if volatility moves down three percent just after the trade is put on, there is no price where we lose money.  Imagine if all of our trades went this well!  Our max loss becomes a gain of $10.30.

The lesson in this is, again, to make sure you know how volatility will affect your positions before you put them on.

Now, let’s take a look at how this trade looks upon expiration of the long call we have in February.

This graph assumes volatility hasn’t moved since initiation.  As you can see, our max loss occurs if the SPY trades for 148.03 on February expiration and our breakeven points are 145.13 on the downside and 151.04 on the upside.  This isn’t bad considering we only need SPY to move down less than half a percent in order to make money.  We do incur losses if the SPY stays neutral or moves up a bit, however.

Short Calendar Spread at expiration

Next, the same graph on February expiration, except with volatility having moved against us, up three percent since initiation to roughly 15.

Short Calendar Spread at expiration +3 implied vol

We can see that increased volatility crushes this trade since we are short.  Our max loss now moves all the way up to $162.90 if SPY trades at 148.03 on February expiration and we now need SPY to trade below 143.68 in order just to breakeven.  This is clearly not what we were looking for when opening this trade as we were short volatility and were trampled as a result.  This trade can still be profitable if volatility moves against us but it is an uphill climb, requiring a substantial move in one direction or the other to breakeven.

Finally, let’s take a look at what happens if volatility moves with our position and falls three percent upon February expiration, to about 9.

Short Calendar Spread at expiration -3 implied vol

This is a much prettier picture for us.  Our max loss is now only $64.80 if SPY trades at 148.03 on February expiration and our breakeven points are now 146.47 on the downside and 149.60 on the upside.  This gives us a huge range in which we can make money.  Obviously, this is the ideal situation for a short calendar call spread.

So What Happens When The First Option Expires?

You may be wondering what happens after the front month option expires in a calendar spread.  The answer is that you are left with only the other option in the spread and this will result in you either being naked long a call or naked short a call.  Depending on your view of the underlying, this might be exactly what you want but being naked short any option carries enormous risk.  This is where you need to judge for yourself if you want to cover or sell the remaining option or ride it out until it expires.  Of course, there are ways to spread out of the last option you have or turn it into another calendar spread.

For instance, let’s assume you had the long calendar call spread trade on from above.  After the February option expires, you are left with just a long March call.  You can either just ride the long call or you can sell a further OTM call if the trade is moving with you.  For instance, let’s say the SPY is now trading at 148; you may want to sell a 150 call against your 148 to make a bull call spread.  This will lock in some of your gains and protect you from losses.

Similarly, if you had put on the short calendar call spread and you were suddenly left with only the short March call, you may want to buy a further OTM call against it in order to make a bear call spread.  If the trade is moving against you, you can either just liquidate or buy a further OTM call to cap potential losses while waiting for the underlying to move with your trade.

There is an endless supply of ways to adjust these trades depending on what happens during the front month’s lifespan and you can decide at expiration if you need to liquidate, adjust the trade or just ride it out.

Summary

Calendar spreads are varied in their formats and uses.  They are a simple instrument that can be altered to fit any viewpoint on a stock or ETF.  In addition, we’ve only looked at call spreads here but calendar put spreads are virtually identical except that they use puts instead of calls.  As a result, the Greeks will be reversed but calendar put spreads can still be used to be bullish, bearish or neutral, just like calendar call spreads.

Just make sure you understand very clearly what price movements in the underlying will do to your position and above all, make sure you understand what volatility changes will do to your position.

Always have a strategy to get out of the trade if you need to.  This includes if the trade is moving against you and you are short, in addition to knowing what you are going to do when the front month contract expires.  Also, you’ll want to have a plan in the event you are proven correct and the trade works for you.

If you can master these and keep a level head while trading, you are well on your way to succeeding using calendar spreads.

9 Comments
  1. Could you suggest me some software for backtesting strategies with options (calendar spreads, condors, straddles, strangles….etc)?
    tnx

    1. Hi Milos, if you’re in the US, Think or Swim is very good. Otherwise try Option Vue. Let me know how you get on.

      1. No, I am in Europe, so I will try option vue right now.
        Tnx so much, I’ll let you know.

  2. Bob says:

    Josh,

    I find OptionVue to be an invaluable tool when it comes to backtesting. Saying that, one needs to be mindful of some intricacies for proper modeling.

    For example, when it comes to most strategies OV does an overall good job but every now and then the modeling is off. The culprit, many times, is that the IV is off. This could be a result of an old print, errant EOD data, thin volume, etc. One way to over come this is to look at the IV of your target option and compare it to the IV’s of other options listed above and below. It should fit inline with the progression of IV’s as they are listed. Also, I find 15:00 to be a good backtest time as it avoids the lack of volume issues from earlier in the day and the peculiar fills at EOD.

    When it comes to modeling calendars, there is more. This applies to all modeling systems, including OV7. There seems to be an inherent problem in that these systems assume the IV of the back month option will become that of the front month….and this is not always the case. Too often, the model will show a favorable profit profile but in reality you will see profits “sink” as the trade progresses. The folks at OV allows the user to switch the IV component of the software program between “variable” and “uniform”, as well as the “CEV”, but I found this to be of little use to me. (I am meeting up with OV’s Steve Lentz at the NYC Trader’s Expo….I’ll ask about modeling calendars.)

    Calendar side note: I used to regularly trade calendars into earnings to capture a modest 8-15% but what I have experienced in the last few quarters this has been increasingly difficult to do. Mark Sebastien, of OptionPit, explained to me that the liquidity providers have been pricing options into earnings such a way that the rise in IV’s in both the front and back month’s does not yield much profit for this type of play.

    1. Josh Arnold says:

      Hi Bob, I agree that most or all models will assume back month IV will become the front month IV but I think this is a necessity instead of an issue with the programming. It stands to reason that the same option (ATM, for example) for the same security with the same time until expiration should (barring any news event) trade at the same IV. I understand the real world isn’t that simple but I’m not sure it is a flaw in the models so much as a necessary evil of trying to predict future prices. We don’t have any forward information that would suggest the back month IV won’t converge with front month IV so I’m not sure we can model anything differently, all else equal.

      Thanks for reading,

      Josh

  3. agnnis bingamin says:

    thanks learned alot about calender spread…

  4. Ethan says:

    Hi there, awesome article. Would you please advise us some adjustments to fix our calendar spreads and be more specific on the entry criteria?. thanks

  5. Lee says:

    Hi, great article on calendar spreads!
    I have a question regarding the short calendar strategy: because I’m buying the front month and selling the back it severely increases my buying power. Is there a way to use contingent orders like take profits, stops etc to automatically close both trades at expiration? Any tips on how to reduce buying power would be greatly appreciated. Lee.

    1. Gavin says:

      Hi Lee, I’m sure there is, but to be honest I don’t use contingent orders, so not sure I’ll be much help. Maybe check with your broker?

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