Calendar Spreads: Timing the Market with Options

It's time to talk about the spread with three names and two personalities. Calendar spreads, a strategy constructed with a short shorter-term option and a long longer-term option with the same strike price (and the same underlying, both calls or puts), are also referred to as time spreads.

Because they involve options in different expiration months, calendar spreads imply an investor is “trading time,” often selling a near-term option to help pay for a longer-term option he or she may want to own for more exposure to expected future price movement.

The third name for calendar spreads is horizontal. This comes from the “spatial” relationship option series listings used to have on trading floor wall boards and screens, when one expiration month series might sit side-by-side with the next month in chronological progression. Thus, investors trading a spread across different expiration series (what we call “quote chains” now in the electronic trading world) were moving “horizontally” in time.

Personality #1

We already introduced one of the calendar spread personalities—the one that lets traders buy a longer-term call or put with help from selling a near-term option. This is how many option traders approach the calendar spread.

For instance, let's say an investor wants to own an April 2011 call in Halliburton (HAL) because he wants to secure exposure to at least three months of upside price movement. In the short term, however, he thinks chances are slim for the stock to move anywhere (during the low-volume trading atmosphere of late December).

One way the investor could play this “quiet now, with upside later” thesis is by buying the at-the-money April 42 call for $2.35 and selling the shorter-term January 42 call for $0.70, paying a net debit of $1.65 (with the stock trading around $40.23 a share). Important dates to keep in mind are January options expiration on January 21 and Halliburton earnings on January 24 before the open.

The best outcome for this trade — and for most calendar spreads of this nature — is for the stock to trade as close to the strike price as possible through January expiration without going above it (which causes the options to go in-the-money). That way, the spread has the most value, especially as the near-term January option rapidly loses time value and the April option has its highest time value (without volatility moving higher).

Below is a snapshot from the OptionsHouse profit/loss calculator of this spread one day before January expiration with the underlying right at $42. It shows the premium collected from the January call as fully realized theoretical profit.

This means that, theoretically, the investor should be able to sell the spread he bought for more than the $1.65 he paid because it will cost little or nothing to buy back the short January option and he gets to sell the April call for a higher premium since the stock moved higher from $40.23 to $42 with little decay in the longer-dated option.  Note, however, that sharp gains or losses in the stock can result in unlimited losses to the upside and significant losses to the downside.

If the trader's interest is primarily in owning the April call for some time period going forward, he will likely want the January option to expire worthless and then to be left with a long April call he bought at a discount (thanks to the credit collected for selling the front-month call).

At that point, the position “morphs” into a long call. The investor can sell or roll this call at any point up through April options expiration.  Gains are unlimited for a long call above the breakeven price while losses are contained to the premium paid.

The scenarios that the investor will least likely want to see occur would be either a very large rally before January expiration, or a huge sell-off in the name.  In both of those cases the extra time value out to April will be minimized, so the calendar spread price will decrease significantly. Alternatively, he always has the right to close the spread anytime before expiration or assignment. And depending on his broker's guidelines and rules, he may be able to “trade out of” the short stock position and keep the long call open if he requests this and if he has sufficient capital and trading approvals.

Personality #2

The other way you can look at calendar spreads is the way option professionals usually do — as a volatility trade between expiration months. The most common way option pros make their living with “volatility arbitrage” is by selling near-term options when volatility appears substantially higher than farther-dated months.

Traders who are willing to sell near-term volatility in quietly uptrending markets may find the long call calendar spread a useful tool. Others may simply like the idea of financing a long-term call purchase with the time decay of a soon-to-expire call. Calendars can also be done with puts and with either of the same two techniques: as a “vol” trade or as a directional trade in a quietly downtrending market.

The great thing about the calendar spread is that it can give you two potential ways to profit in two time frames. Traders can either attempt to capitalize quickly on volatility differences and rapid time decay of the near-term leg, potentially selling out of the spread within weeks or days. Investors might also opt to trade the spread hoping the short-term position expires worthless, letting them keep the time value premium and riding the long option further with a directional bias. Risk is significant to both the upside and downside through the life of the spread, however, should the stock move significantly higher or lower.

Note: This content was previously published by the Options News Network.1 It has been edited slightly from the original version.  The Options News Network was affiliated with OptionsHouse, LLC, through our mutual parent company, PEAK6 Investments, LP.