Options trading is a way to access an array of strategies specially designed for various market conditions and different levels of risk tolerance. One of these is the calendar spread, a plan that consists of buying and selling options which have the same strike price but different expiration dates, through which traders gain from time decay and volatility changes along the way to their decision. Want to learn how this strategy works, its advantages, and ideal market conditions? Keep reading for our detailed guide.
What is a calendar spread in options trading?
A calendar spread involves buying and selling the same type of option at the same strike price but with different expiry dates, done simultaneously.
The primary goal of this options strategy is to make money on the loss of time value and the fluctuations in implied volatility while keeping the risk at a minimum, most often in cases when the price of the asset involved is not moving. The method also includes selling a short-term option and buying a longer-term one.
How does a calendar spread work?
A calendar spread is an options trading strategy that involves buying and selling the same type of option (either calls or puts) with an identical strike price but different expiry dates.
Usually, the position that is of a longer duration is purchased, and the one that is of a shorter duration is sold.
The strategy is designed to take advantage of the fact that the short-term option’s faster time decay will be offset by the long-term option’s slower time decay. Maximum performance is attained when the underlying asset’s price remains close to the strike up to the short‑term expiry.
A large move away from the strike can cause the spread to lose some of its value. The risk is typically confined to the amount initially paid as the net cost to open the spread.
Calendar call spread vs calendar put spread
Both calendar call and calender put spreads share the same structure but differ in the option type used and the market outlook they suit. This comparison is intended to help you determine which option aligns most closely with your market outlook.
| Feature | Calendar call spread | Calendar put spread |
| Structure | Purchase and sell call options with an identical strike price but differing expiry dates. | Purchase and sell call options with an identical strike price but differing expiry dates. |
| Market Outlook | Neutral to mildly bullish | Neutral to mildly bearish |
| Ideal When | Expect the underlying asset to stay stable or rise slightly | Expect the underlying asset to stay stable or fall slightly |
| Profit Source | Time decay, modest upward movement, and potential rise in implied volatility | Time decay, modest downward movement, and potential rise in implied volatility |
| Risk Profile | Limited risk | Limited risk |
| Maximum Profit Potential | When the asset price is near strike at short option expiry and slightly higher | When the asset price is near strike at short option expiry and slightly higher |
Calendar spread example
Let us first break down the concept of a calendar spread with a simple example.
Suppose a stock is trading at ₹3,000. A trader thinks that there will be no change for a short period of time. In this case, they establish a calendar spread by:
- Selling a one‑month call option with a ₹3,000 strike for ₹50.
- Buying a two‑month call option with the same strike for ₹120.
The net cost (debit) is ₹70.
If the stock remains close to ₹3,000 till the short‑term expiry, the sold call will almost be worthless. The trader gets the long‑term call, which can be worth the same or even more in case of the volatility ascent or the price moving in the right direction. The only risk is the initial ₹70 paid.
Calendar spread payoff & profit potential
Analysing the payoff and profit potential of a calendar spread option strategy could lead to a better understanding of how the strategy performs under different market conditions.
Payoff:
The best result is achieved when the price of the underlying asset remains near the strike price at the short‑term option’s expiry. Here, the sold option is usually of no use, while the longer‑dated option still has time value. Large price changes beyond the strike will decrease the spread’s value.
Profit Potential:
Profits are generally small and reach the highest level near the strike price at short‑term expiry. They come mainly from the quicker time decay of the short option compared with the long one, and can be still higher in case of higher implied volatility. The maximum loss is confined to the initial net debit paid.
Risks & drawbacks of calendar spreads
Although calendar spreads can be a good options strategy for some market conditions, they have some specific risks and limitations that need to be understood by traders.
Risks:
- Price movement risk – Big moves in the opposite direction of the selected strike price can wipe out the potential profits.
- Volatility sensitivity – A sudden change of implied volatility, especially a steep fall, will most likely affect car rental if such a situation occurs.
- Early assignment risk – American options give you more rights and freedom. In particular, the unexercised short leg may be performed before the expiration, thus, there might be more obligations.
- Execution and cost risk – Handling two options raises commission and the chance of bad execution.
Drawbacks:
- Capped profit potential – Profits are usually quite low and limited, which makes the strategy less attractive in volatile markets.
- Underperformance in trends – Performs best in stable markets and can struggle in strongly bullish or bearish conditions.
- Timing dependency – The profitability depends on the coincidence of the expiration of the short-term option with the strike price.
- Ongoing management needs – It needs supervision and changes to keep the risk–reward balance as required.
When to use a calendar spread
Some of the most suitable situations to deploy a calendar spread option strategy are:
- Most suitable when the underlying asset is expected to remain stable near a specific strike price until the nearer-term option expires.
- Works well in neutral or sideways markets where little price movement is anticipated over the short term.
- Allows traders to capitalise on the faster time decay of the short‑term option compared with the long‑term option.
- It may also prove effective when a rise in implied volatility is anticipated, as this can enhance the value of the longer‑dated option.
- Used to reduce the net cost of a longer-term option by selling a nearer-term option at the same strike.
- Offers limited risk with modest profit potential, aligning best with well-defined market views rather than highly volatile conditions.
Calendar spread vs diagonal spread
When choosing an options spread strategy, understanding the distinction between a calendar spread and a diagonal spread can help refine your approach based on your market view and risk tolerance.
| Feature | Calendar Spread | Diagonal Spread |
| Strike Price | Employs the same strike price for both options. | Utilises different strike prices for each option |
| Expiry Dates | Involves options with different expiry dates, where the near-term option expires sooner and the long-term option expires later. | Involves options with different expiry dates, combining a shorter-term option with a longer-term option. |
| Market Outlook | Most appropriate for neutral market conditions where minimal movement in the underlying asset’s price is anticipated. | Designed for directional market views where you expect a moderate move in the underlying asset’s price. |
| Profit Source | Derives its gains primarily from the effects of time decay and fluctuations in implied volatility. | Generates profits from time decay, changes in implied volatility, and favourable price movement. |
| Risk | Carries limited risk and moderate complexity. | Carries higher risk and greater complexity due to the use of different strike prices and expiries. |
FAQs
A calendar spread is usually seen as a neutral approach since it mainly makes money when the price of the underlying asset is near the strike price at the time the short-term option expires. It might be a bit bullish or bearish based on changes, but it is basically intended for calm market conditions instead of significant directional changes.
The break-even for a calendar spread can change quite a bit because of different expiry dates and other factors that are changing. Typically, there are two break-even points, one that is over and one that is under the strike, where the value of the spread equals the initial debit. It is influenced by the underlying value, time decay, and implied volatility at short-term expiry.
Yes, losses are possible on a calendar spread if the underlying asset price deviates significantly from the strike, which leads to a decrease in the value of both options. The fall of implied volatility, the possibility of early assignment with American-type options, and the costs of transactions may add to the loss as well. In general, losses are limited to the extent of the initial net debit paid.
To manage risk or generate more premium, a calendar spread may be altered by rolling the short-term option to a later expiration date or a different strike price. Market trend and volatility alterations may dictate the decision to close one leg or add new positions. Regular supervision is required to keep the strategy working well.