Definition
A calendar spread, also known as a horizontal spread, is an options or futures strategy that involves simultaneously buying and selling two contracts for the same asset with the same strike prices, but different expiration dates. The goal is to profit from the time decay of options as contracts that are closer to expiry usually decay faster than those with later expiry dates. This strategy is often used in hopes that the asset’s price will be near the strike price on the expiration date of the near-term option.
Key Takeaways
- A Calendar Spread refers to a strategy in options or futures trading where an investor simultaneously buys and sells two contracts with the same strike price but different expiration dates.
- The aim of this strategy is to take advantage of the differences in time decay between the two contracts, with the expectation of a profit when the near-term options expire faster than the long-term ones.
- While this strategy allows investors to limit their risk and potentially earn profits from the time decay, it requires careful execution and management. Strategies may include the Horizontal, Vertical, and Diagonal spread, each offering different risk-reward profiles.
Importance
The finance term “Calendar Spread” is an important concept as it is a strategic method used in options trading. It involves the simultaneous buying and selling of two options contracts with the same strike price, but with different expiration dates.
This strategy allows an investor to potentially profit from the time decay of options prices, essentially betting on which options contract will lose value faster. Typically, the investor sells an option with a near-term expiration, which is likely to lose value faster, and buys an option with a later expiration.
The calendar spread is a crucial strategy for hedging purposes and to lessen the impact of time decay on the portfolio. It can also be used to take advantage of increasing or decreasing volatility in the options market.
Explanation
The purpose of a Calendar Spread, which is also commonly referred to as a horizontal spread or time spread, is to take advantage of the differences in time decay rates between options with different expiration dates. This type of spread involves buying and selling two options of the same type (calls or puts), at the same strike price, but with different expiration dates.
Traders use this strategy with the expectation that the option they sold will lose value faster than the option they bought, thereby netting a profit. This strategy is employed predominantly by seasoned traders who are making a bet on the market remaining relatively stable over a short period, while expecting a longer term volatility.
It allows the traders to benefit not from the directional movement of the asset, but from the passage of time and changes in implied volatility. Calendar Spread serves as a way for investors to mitigate risk while potentially making a profitable trade, which can be an effective method for managing potential losses in uncertain market conditions.
Examples of Calendar Spread
A calendar spread is an options strategy that involves buying and selling two options (typically either calls or puts) with the same strike prices but different expiration dates. The trader profits from the difference in time decay (the decline in an option’s value as it approaches its expiration date) between the two options. Here are three real-world examples:
Stock Trader Example: Suppose a trader has a bullish outlook for QRS company, which is currently priced at $50 per share. They might sell a QRS call option with a $55 strike price and a one-month expiration date for a premium of $4, and simultaneously buy another QRS call option with the same strike price but a three-month expiration date for a premium of $
This calendar spread will cost the trader a net $2 ($6 – $4). If QRS is near the $55 price level by the first expiration date, the short option will expire worthless, and the trader can potentially profit from the longer-term call option as the company continues to perform well.
Commodity Trader Example: A commodity trader expects the price of crude oil to rise significantly in the next half-year but stay steady for the next two months. The trader buys a crude oil futures call option for December with a strike price of $60 per barrel and sells a crude oil futures call option for August with the same strike price. If the prediction is correct, the August option may expire worthless, while the December option could rise significantly in value.
Bond Trader Example: A bond trader expects interest rates to remain stable in the near term but increase in the long term, which would decrease the price of bonds. They can do a calendar spread by buying a long-term put option on a bond ETF and selling a short-term put option with the same strike price. If rates indeed rise in the long term, the strategy could profit from increased value of the long-term put and the short-term put expiring out of the money.
FAQs on Calendar Spread
What is a Calendar Spread?
A Calendar Spread, also known as a Horizontal Spread or a Time Spread, is a strategy that involves buying and selling two options (either calls or puts) of the same underlying asset and strike price but different expiration dates. The objective is to profit from the decay of time value of the options.
How does a Calendar Spread work?
In a Calendar Spread, an option with a nearby expiration is sold and an option with a later expiration date is bought. The idea is that the nearby option will lose value faster than the later-expiring option, allowing the trader to profit from the difference.
What are the risks and rewards of a Calendar Spread?
The risk in a Calendar spread is limited to the premium paid to initiate the trade. The potential reward is limited as well but can be high relative to the risk, depending on the underlying stock’s performance. It’s important note that profits will only be realised if the price of the underlying asset remains near the strike price at the expiration of the near-term option.
Can I use Calendar Spread with any asset?
While Calendar Spreads are commonly used with stocks, they can also be used with futures, commodities, and currencies. However, they are more complex than simple option strategies and therefore require a higher level of understanding of options trading.
What is a diagonal spread? Is it similar to a calendar spread?
A diagonal spread is similar to a calendar spread in that it involves options of the same type with different expiration dates. But, unlike in a calendar spread, the strike prices of the options in a diagonal spread are different. This strategy combines horizontal spread (calendar spread) and vertical spread (options of the same expiration date but different strike prices).
Related Entrepreneurship Terms
- Options Contract
- Strike Price
- Expiration Date
- Implied Volatility
- Premium
Sources for More Information
- Investopedia – It’s one of the world’s leading sources of financial content and provides various articles, dictionary terms, tutorials, etc. about finance and investing.
- The Balance – This website provides expertly written and broadly covered content about different financial topics including strategies related to options trading such as the calendar spread.
- Options Playbook – It focuses on providing comprehensive information, strategies, and advice on options trading.
- Fidelity – A major brokerage firm that provides insights about different financial strategies including options trades like the calendar spread.
