Advanced Trading Center

CALENDAR SPREAD

The most frequent use of the calendar spread is probably the simple rolling out of a position nearing expiry to a later month. In other words, perhaps you have a buy-write on, and with your short call about to expire, you want to roll it out to a further month to collect more premium. You may also do this to avoid having the stock called away from you.

Nevertheless, there are uses for the calendar spread when you are actually initiating both options simultaneously, rather than closing one to open another. Indeed, the calendar spread is a neat and deceptively simple trade. While the basics are easy to understand and the commissions are low, the trade actually involves some concepts essential to more complex strategies. It's also an exceptionally useful trade for the investor with a strong knowledge of the underlying stock and the upcoming events likely to affect it.

As its name suggests, the calendar spread involves buying an option with one expiration and selling an otherwise identical option that expires at a different time. You are said to be buying or "going long" the calendar spread when you buy the longer-dated option and sell the shorter-dated one. This would also be considered a debit spread, since the option you buy costs more than the one you sell, requiring a net cash outlay even before commissions. Conversely, you are selling the calendar spread when you buy the option with the earlier expiration and sell an option of the same type (viz. put or call) and strike but longer lifespan.

Okay, now that we have the basics out of the way, let's dig in to this fascinating little trade. We'll assume that ABC stock is trading at 51 and we want to look at a trade involving calls struck at 50 with expirations of one and two months, respectively. The one-month call is trading at 2.40 and the two-month at 3.20. It's not necessary to follow how calendar spreads work, but you may want to take a moment to break down each of these calls to understand where their prices come from.

First, consider the manner in which options provide leverage, allowing you to control far more stock with the same amount of capital than you would by buying the stock itself. One way of measuring this is to say that for the life of the option, you are essentially being loaned cash up to the strike price. All you have to put up is the option premium for the right to own that stock if you so choose.

Let's say interest rates are five percent - this was in fact the rate used in calculating these hypothetical option values. That means that over the course of a year, borrowing $50 (the strike price) would cost $50*.05, or $2.50. This comes out to just over $0.20 per month. So, $0.20 of the one-month call and $0.40 of the two-month call are attributable to this leverage, borrowing, financing, or whatever term you prefer.

Remember now that both options are one point in the money, with the stock currently trading at 51. So one dollar of each option price is that so-called "intrinsic value." We thus have been able to explain half, or $1.20, of the $2.40 price of the one-month option, and somewhat less than half of the two-month option ($1.40 of $3.20).

It's useful to go through this exercise when trading a calendar spread so you can focus on how much "pure time value" is in each option. In this case, there is $1.20 of pure time value in the one-month option and $1.80 in the two-month. You may have heard somewhere that option prices are not a linear function of time, but rather depend on the square root of time. If you look at these two numbers you'll see that the pure time value of the two-month call is just a dime or so more than the one-month's time value multiplied by the square root of two.

When looking at a calendar spread, a large discrepancy from this time relationship is probably the market telling you that there is some upcoming event whose range of outcomes is not consistent with the smooth, continuous distribution assumed by most option-pricing models.

Now, let's say you expect the stock to be very static over the next month, but you think that a new product announcement the subsequent month will move the stock far more than the market is pricing in. It would make a great deal of sense in this case for you to buy the calendar spread - buy the two-month call and sell the one-month. (These trades, of course, work just as well with puts).

By doing this, you will initially lay out $0.80. But if the stock stays at 51 for the next month, you will be able to cover the call you sold for about $1, since it will have no time value left. Meanwhile, the call you own is now a one-month call, and it will look quite similar to the one you sold a month ago. Thus we'd expect it to be worth about $2.40.

So on the call you originally sold for $2.40, you pay $1 to close it out, booking $1.40 in profit before commissions. At the same time, you will be showing a paper loss of $0.80 on the call you own that now has a month remaining. So you'll be $0.60 ahead going into the time when you expect to make your big win.

The only real flaw in this logic is that if the stock has really been that stagnant, the market may price volatility lower to the point that you might only get $2.10 or $2.20 for your call if you wanted to sell it. But this is not a major problem for two reasons. First, it is not your plan to sell the call, although it's certainly always nice to have favorable marks. Second, the drop-off in mark-to-market because of lower volatility is unlikely to be large for such a short-dated option.

The last point is actually an important one. Are you familiar with the concept of duration in bonds, where a given change in yield has a much larger effect on the price of long-term bonds than it does on shorter-dated ones? Well, option pricing has an analog in vega (the change in an option's price for a given change in its implied volatility). Changes in expectations of volatility have a much greater impact on long-dated options than on ones expiring in a month or two.

As you can see from the example, the idea with buying a calendar is to take in some premium during an expected short-term lull before the bigger storm you are expecting. The shorter-dated premium takes a big chunk out of the cost of the option you are buying. The ideal outcome is for the stock to close just low enough (high enough) for the shorter-dated call (put) not to be exercised at expiration. In the example above, you'd want the stock to close at something like 49.95. The call you sold would expire worthless and the one you owned would be worth about $1.80. Thus your original net investment of $0.80 ($3.20-$2.40) would have more than doubled.

When you are long a calendar spread, the optimal scenario is for the stock to gravitate to the strike price before the option you are short (the early option) expires. When you are short the calendar spread, you want a big move to take place before the first option expires. There are several ways to think about this. The following, I think, is perhaps the most intuitive. (In fact, as a general rule, a very good way to understand options is to see what happens in an extreme example and then work your way back to more normal conditions).

Let's say you sold the calendar spread and a couple of days later a report came out of widespread accounting fraud at the company. Half of the board of directors is arrested and forced to watch "Love Boat" reruns while awaiting trial. The stock drops from 50 to 20. The chances of it getting back above 50 in the next year - let alone the next two months - are essentially nonexistent. Nobody will pay so much as a nickel for either the one-month or two-month calls, as they are equally worthless. (The $0.20 monthly "leverage fee" is only relevant when there is some reason to believe the option might be exercised).

With both 50-strike options equally worthless, the winning trade was to be short, not long, the calendar spread. (You'll see in a moment that this would have been true even if we had been discussing puts, not calls, in this example). The more expensive option loses more value than the less expensive one - it was walking a higher tightrope, you might say, before they both fell off. Any excess paid for the longer-dated option over and above what was received from the shorter-dated option goes the way of all things.

Now, let's consider the opposite scenario. The company comes out a couple of days after you buy the calendar spread and announces it is being taken over for $65 cash. The stock immediately shoots to the takeover price. The market agrees that the deal is solid and will go through, so that the only difference between the one and two-month calls is the month of financing ($0.20) we discussed earlier. Since both options are certain to be exercised, the financing is absolutely relevant. Otherwise, the extra month of "optionality" is worthless.

You should be able to see that the extra time afforded by the longer-dated part of the calendar spread only has value (other than financing for in-the-money calls) to the degree there is uncertainty about which side of the strike price the stock will be on at both expirations. In other words, when long a calendar spread, the closer to the strike the underlying stock closes at the expiration of the shorter-term option, the better.

This is why, as noted a bit earlier, being long a put calendar spread is a loser when the stock makes a big downward move before the early option expires. It's important to understand this, and since it is not completely intuitive, take the time to run through a few examples in your mind to get comfortable with it.

The last major issue we need to review with the calendar spread is the directional exposure of the trade. You'll see that it can vary rather dramatically, especially when the first option nears expiration and the stock is close to the strike price. This is essentially the concept of "gamma" that option traders often discuss. We'll avoid that term here and borrow from an example I wrote many years ago while watching a basketball game.

Imagine a tie game with 20 seconds remaining. There is going to be a jump ball between two players of equal height and talent. Basically, each team has a 50-50 chance at winning.

Now imagine that the team that wins the jump ball makes a basket with three seconds remaining. Its chance of winning has gone to probably 90 percent or better. The option analogy is the likelihood of an option finishing in the money. If you have an at-the- money call with just a few days to expiry and suddenly the stock shoots up a point or two, the call suddenly becomes a virtual stock substitute.

If you were long the calendar spread (short an about-to-expire call and long a longer-dated one), you suddenly find yourself essentially short the stock and long the long-dated call, which is the economic equivalent of a long-dated put. It's likely that this is not where you intended to be at this point. What this should be telling you is that there's a fine line with very short-dated at-the-money options between doing quite well and doing quite poorly, whichever side of them you are on.

You can avoid this volatility by covering the short-dated option shortly before its expiration, keeping in mind that those who would sell it to you recognize its potential value and will price it accordingly. If you do cover it, you give up a big portion of the advantage of the trade.

Let's go back to our earlier example. We'll say the stock is trading at 49.95 mid-day Wednesday and the shorter-dated option expires at the close of trading Friday. It's trading at 0.50, while the later option, which now has one month and two-and-a-half days to go, costs 1.90. The key to remember is that the 50-cent, short-dated option has tremendous leverage but is also susceptible to rapid decay. The leverage comes from the fact that if the stock goes up by 2.05 (four percent) to 52, this short-dated at-the-money call will go from 0.50 to its new intrinsic value of 2. This represents a 300-percent gain in the option's value, or 75 times the percentage gain in the stock!!

Clearly, in order to induce anyone to sell short something so explosive, you must be willing to pay them handsomely. In this case, that handsome payment is what the person long the calendar spread stands to collect - $0.50 - if the stock doesn't move for a couple of days. Fifty cents may not sound like much, but it represents collecting one percent of the stock's value if the stock essentially sits still for half a week. Keep in mind that for any short period of time, the most likely outcome (except with some special event like a legal settlement) is that the underlying asset's price will not change. Since there are 104 half-weeks in a year, this means that by being short this very short-dated call, you will make an annualized return of (1% x 104) or more than 100 percent for the most likely outcome!

So as the owner of the calendar spread, even as you stand to collect an annualized return of 100+ percent for the short part of your position (the short-dated option) if you get your best-case scenario, you stand to lose only about a dime of the value of the option you own, from 1.90 to 1.80. This is because of the way options experience decay in their value. They tend to hold their value until fairly late in their lives, when they start to lose value quite rapidly. (You can see this by the rapid decay of the short-dated option discussed here, which goes from fifty cents to zero in half a week if the stock doesn't go up).

So, let's summarize. If you are long the calendar spread, hold on to your position and get the optimal outcome, that is the short option becomes worthless and the one you are still long, which still has a month of time value, is worth $1.80. Recall that when you initiated the position, you paid $3.20 for the longer-dated option while selling the shorter-dated one for $2.40, a net outlay of $0.80. Now, you own an unencumbered option worth $1.80. Your best-case scenario has resulted in a profit of $1, a gain of better than 100 percent of your risk capital.

The foregoing presumes that you were willing to take the risk of the stock running up before the short-dated call expired. If you don't want the short-term risk, you can unwind the trade Wednesday afternoon for a $1.40 credit. You do this by buying the short-dated call back for $0.50 and selling the longer-dated call for $1.90 less commissions. This still is hardly a poor return on the original $0.80 investment. Or, if you want to maintain your long bias because of your original view, you can simply cover the early call. You will have made a $1.90 profit on it versus a smaller loss on the longer-dated option ($3.20-$1.90, or $1.30 loss to be precise).

The one thing you presumably want to avoid is to have the market anticipate the event you foresaw and gun the stock before the early option expires. That should be fairly clear by now, both because we've seen that a big move before the early option expires is bad for those long the calendar spread and because (in this case) the quick upward move turns the calendar spread into a synthetic put for someone who wanted to own a call.

To show some numbers, suppose the stock runs to 53 at expiration and you have taken no action. Assuming you want to maintain the long bias, you must cover your short at 3 (in actuality, probably a nickel or dime higher plus commissions) while your long is worth about $3.80. So you are basically flat on your trade - you paid 80 cents and it's worth 80 cents. It could have been worse (and would have been had the stock gone a lot higher), since there is still some premium left in the call you own. But in trying to maximize your winnings, you let a nice profit get away. What is it they say about bulls, bears, and pigs?

As we said, the calendar spread is a simple trade with a lot of nuances. The key is to monitor the trade carefully in the last week of the first option's life, whichever side of the trade you are on.

Go back for a moment to the basketball analogy. If this same sequence of events - a big move by the stock, or a basket by one team - had happened midway through the game, the same basket would have had at most a minor effect on the outcome of the game. Put another way, any given move in the stock well before the first option's expiration will have far less effect on the position than the same move just before the first expiration. The point is that if options are nearly at the money and near expiration, they must be monitored closely. One moderate move in the stock can dramatically change the whole profile of your trade.