The Calendar spread involves simultaneously purchasing a call or put and selling a call or put on the same underlying and with the same strike price but with different expiration dates.
We’ll examine the “long” calendar spread in which we purchase the longer dated option and sell the shorter dated option. Because the value of options increase with more time remaining, the spread will involve a net debit and also has unlimited profit potential.
You might use the calendar spread when you are long term bullish (call calendar) or bearish (put calendar) on the underlying stock, but also expect a period of minimal movement in the near term. Counter-intuitively, if implied volatility increases (but the stock price itself doesn’t move) it will make our spread more valuable. So we’re looking for an increase in implied volatility without an increase in actual volatility.
You’ll recall that the value of options decays more quickly as expiration approaches, so with minimal movement in the underlying, we’ll be making money as the value of the option we’re short moves toward zero. Long-term options have more vega – or price sensitivity to changes in implied volatility – so our spread will also increase in value if implied volatilities rise.
If the underlying moves quickly in either direction prior to the expiration of the near-term option, the spread will move toward zero and we’ll lose the entire premium. If the stock price stays about the same, we’ll see the maximum profit. We don’t yet know exactly what that number will be, because we don’t know what the implied volatility of the long dated option will be at that point – but the higher, the better.
So if we believe that short-term expectations will raise implied volatility but the stock probably won’t actually move right away, buying a calendar would be the appropriate trade.
Some Caveats
Don’t trade calendars around earnings or ex-dividend dates. If there’s an earnings announcement or an ex-dividend date that occurs in between the two expirations, the spread will not behave as expected.
Also, for this explanation we’ve assumed that the entire spread will be closed before the first option expires. That doesn’t necessarily have to be the case, however.
In the case of a call calendar, if the stock price is below the strike at the first expiration, the near-term call will expire worthless, so you don’t necessarily have to close the spread. We can simply let that option expire worthless and decide whether we want to sell the remaining long call or hold it longer. The risk at that point would be whatever premium we forgo by not selling the remaining long option.
If the stock price is above the strike price, both options will be in-the money. We can close the spread as a spread and keep whatever premium difference exists between the options at that point. Or we could also let the near-term call expire in the money which will involve us selling 100 shares of stock at the strike price.
As we know from previous discussions on Call-Put Parity, if we own one call and are short 100 shares of the underlying stock, we have a position that will exactly replicate the performance of owning one put on the same strike.
So basically, if the stock goes down and you expect it to rally back, or if the stock rallies and you expect it to fall back, you can do nothing at the first expiration and you’ll own a call or a put, respectively, in the second month. If you expect either move to continue, you should close the remaining option(s).at or prior to the first expiration.
-Dave
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