For example, Steve the investor anticipates ABC Company to have a flat to slowly rising price trend. To profit from this, he decides to purchase options contracts following a calendar spread strategy. ABC Company is currently trading at $100 per share. Steve purchases a longer-term six-month call option with a strike price of $103, while simultaneously selling a shorter-term two-month call option with a strike price of $103. Steve’s maximum gain is unlimited after the short-term option expires. Here’s how Steve will profit from this strategy, assuming the stock market follows his estimated price movement of a flat to slowly rising price trend:
If ABC Company is below $103 at the expiration of the three-month option that Steve sold, then the option expires worthless and Steve profits from the premiums received.If ABC Company is above $100 per share (the price it was valued at the time of purchasing the long-term call option), Steve has the option to potentially sell the option for a profit, hold onto it if he thinks the underlying stock will surpass $103 before the six-month expiration date, or implement other spread strategies by selling other short-term options on the same underlying stock.
By purchasing a longer-term call option while selling a shorter-term call option at the same time and the same strike price, Steve is limiting his overall risk exposure from two options that benefit differently when the underlying security increases or decreases in value.
How Calendar Spreads Work
Calendar spreads are beneficial when the underlying security is expected to have neutral to moderately rising price trends. Because there are multiple contracts involved in a calendar spread strategy—both long and short positions at varying expiration dates—it’s important to understand how the movement of the underlying security will affect the net gain/loss of your calendar spread strategy. Consider the three potential price-movement scenarios following the same example as discussed above with Steve the investor: If the short-term call is exercised before the expiration date, then the loss may be larger than the gain on the long-term call option position, equaling a net loss.
Types of Calendar Spreads
All calendar spreads follow the strategy of buying multiple derivative contracts (options or futures) at the same time to hedge against risk and/or maximize potential gains. However, you will often hear different calendar spread strategies that are worth taking note of. Some of these include:
Horizontal Spreads: This is a calendar spread in which the derivative contracts purchased have the same strike prices but different expiration dates.Diagonal Spreads: This is a calendar spread in which the derivatives purchased both have different expiration dates and different strike prices.
What This Means for Individual Investors
Implementing a calendar spread requires a basic understanding of derivatives, such as options and futures contracts. In most cases, calendar spreads are used by more experienced investors due to the complexity of the strategy. An investor might consider employing a calendar spread if they anticipate the price of a security to remain flat or slowly increase in value over time or if they want to profit from owning short positions in a security. Understanding time decay and implied volatility is crucial to the success of a calendar spread. It may also be used to minimize risk when trading options.
