Calendar Spread: Meaning, Strategy and Example

Options trading is a highly popular segment in the Indian stock markets. However, it is not easy. There are many nuances to options trading, like learning about options greeks, various options trading strategies, time decay, implied volatility, and more. While traders use various options trading strategies to navigate the options market, calendar spreads are a popular name. Dive into this blog to learn all about calendar spread strategy and how it works to understand options trading better. 

What is a Calendar Spread?

A calendar spread is an options trading strategy that involves buying and selling options with the same strike price but different expiration dates. It is betting on how the underlying asset's price will move over time. 

Under this strategy, traders sell a short-term option and buy a longer-term option. This move aims to profit from the difference in how these option’s premiums lose value as time goes by (also known as time decay). This strategy can help traders manage risk and benefit from volatility or time decay.

How Calendar Spread Works?

A calendar spread is a strategy that leverages the differences in time decay between options with the same strike price but different expiration dates. The steps to trade using the calendar spread strategy include,

• Start by selling a short-term option and buying a longer-term one with the same strike price.

• Due to the effect of time decay, the short-term option will lose its value faster than the long-term option, which can create a profit opportunity.

• As the expiration date of the short-term option approaches, its value drops more rapidly.

• If the price of the underlying asset stays around the strike price, traders can buy back the short-term option for less than what it is sold for while still holding the longer-term option.

This strategy benefits from stable or slightly volatile markets and can be a way to earn a profit from the passage of time and changing volatility.

Example of a Calendar Spread

Let us consider the following example to understand the calendar spread strategy.

Trader A is interested in Company X's stock, which is currently trading at Rs. 1000, and believes the stock price will stay close to Rs. 100 over the next few months. The trader will apply the calendar spread strategy in the following way. 

• Sell Short-Term Option:  Trader A can sell a call option with a strike price of Rs. 1,000 that expires in one month and receives a premium of Rs. 20 for this option.

• Buy Long-Term Option:  At the same time, Trader A can buy a call option with the same strike price of Rs. 1000 but with an expiration date three months from now, paying a premium of Rs. 40 for this option.

In this case, the net cost for setting up the calendar spread is Rs. 20 (40-20).

Here is how this calendar spread will play out - 

• Initial Cost: The net cost of this calendar spread is Rs. 20 [Rs. 40 (paid for the long-term option) - Rs. 20 (received for the short-term option).

• Profit Scenario: If the stock price stays close to Rs. 1,000 when the short-term option expires, Trader A can buy it back at a lower price, potentially making a profit. Meanwhile, the long-term option may increase in value or stay stable.

• Risk Scenario: If the stock price moves significantly from Rs. 1,000 or implied volatility drops, the spread may be less profitable, and Trader A could lose the initial Rs. 20 invested.

Pros and Cons of Calendar Spread

The pros and cons of calendar spread strategy are

Calendar Spread Strategy

Based on their options, traders can use different types of calendar spread strategies. Here is a brief explanation of the types of calendar spread strategies. 

Long Calendar Spread

A long calendar spread is where a trader buys a long-term option and sells a short-term option with the same strike price. The goal is to profit from the time decay of the short-term option, which loses value faster than the long-term option. This strategy works best when the underlying asset's price is expected to stay stable in the short term but may move significantly later. This option can be exercised with both call and put options.

Short Calendar Spread

A short calendar spread involves selling a long-term option and buying a short-term option with the same strike price. This strategy is used when the trader expects significant price movement in the short term. It is riskier because the long-term option can gain value quickly if the price moves dramatically. This kind of calendar spread can be exercised with call and put options.

Diagonal Calendar Spread

A diagonal calendar spread is a modified calendar spread in which the trader buys and sells options with different strike prices and expiration dates. This strategy aims to profit from both time decay and price movement. It offers more flexibility and can be adjusted based on the trader's outlook on the market.

Double Calendar Spread

A double calendar spread is a modified calendar spread that involves setting up two calendar spreads using calls and puts. The trader buys long-term options and sells short-term options for both calls and puts. This strategy is useful when expecting significant volatility but is uncertain about the direction of price movement, allowing profit from large moves in either direction.

Difference Between a Long Calendar Spread and a Short Calendar Spread

In the paragraphs above, we discussed long and short calendar spreads. Here is a snapshot of the main differences between the two strategies.

Conclusion

The calendar spread strategy is a versatile options trading technique that involves buying and selling options with the same strike price but different expiration dates. This strategy can be tailored to suit different market conditions and benefit from time decay. Understanding the nuances of calendar spread strategy can help traders to effectively navigate options trading and make informed trading decisions based on their market expectations and risk tolerance