What is a calendar spread and how do you use it?

What is a calendar spread?

A calendar spread is an options trading strategy where you simultaneously buy one options contract and sell another. In other words, you open two positions at the same time – one long, one short. The two contracts you trade will be of the same type, ie they’ll both be calls or puts. They’ll also have the same underlying asset and strike price but different expiration dates.

Also known as a time spread, counter spread and horizontal spread, this strategy aims to capitalise on differences in options prices due to time decay (theta) and implied volatility.

How does a calendar spread options strategy work?

A calendar spread works through a series of interconnected steps and concepts:

1. Setup and position: you’ll simultaneously buy one options contract and sell another. The two contracts will have the same underlying asset and strike price but different expiration dates. Typically, you’d sell a near-term option and buy a longer-term one. For example, you might sell a call that expires in 30 days while buying a call that expires in 90 days

2. Time decay and profit mechanism: calendar spreads can profit from time decay rates. The near-term (short) option loses value faster than the longer-term (long) option, widening the spread (ie the difference between the two options’ values) and creating potential profit opportunities

3. Ideal scenario and risk: the maximum profit typically occurs if the underlying asset's price is at the strike price when the near-term option expires. At this point, the short option will expire worthless, while the long option will still have value. However, if the asset's price moves significantly away from the strike price, both options may lose or gain value, potentially resulting in a loss

4. Adjustments: you can adjust your positions as market conditions change. For example, you could roll the near-term option to a new expiration date

Note that calendar spreads generally work best in stable market conditions, where the underlying asset's price will likely not move dramatically before the near-term option expires.

How to trade calendar spreads

1. Open an account with us

2. Choose your underlying asset

3. Take your positions

4. Monitor and manage your positions

Open an account with us:

To trade calendar spreads with us, you’ll need a US options and futures account. This account enables you to buy and sell options contracts (rather than just speculate on their prices), which is essential for the strategy. You can open a US options and futures account by filling in a short form, where we’ll ask you about your trading experience. Once we’ve verified your details, you’ll be able to fund your account and start trading online.

Choose your underlying asset:

Use the search function on our US options and futures platform to find and select the asset you want to trade on. Make sure you do thorough research on the asset before taking your positions.

Short put calendar spread example

Suppose Amazon (AMZN) is trading at $3,300 per share and you anticipate significant volatility due to an antitrust investigation. You decide to implement a short put calendar spread with a strike price of $3,200.

You place the following trades:

• Buy 1 AMZN $3,200 put expiring in 30 days for $55

• Sell 1 AMZN $3,200 put expiring in 90 days for $110

In this inverted calendar spread, you're selling the longer-dated option and buying the shorter-dated one. This creates a net credit of $55 per share ($110 - $55). With each standard equity options contract controlling 100 shares of the underlying stock, this spread generates a net upfront credit of $5,500.

If AMZN plummets to $3,000 due to negative investigation results, your short-term put might be worth $200, while the long-term put might be worth $250. Closing the positions would result in a $5 profit per share ($200 - $250 + $55 initial credit), or $500 for the spread. Alternatively, if AMZN surges to $3,500 on strong e-commerce growth, for example, both puts might become worthless, enabling you to keep the entire $5,500 initial credit as profit.

For all these examples, it's crucial to remember that options trading carries significant risks. Real-world outcomes can be affected by numerous factors, including market volatility, company-specific events (in the case of stock or stock-related options) and broader economic conditions.

Benefits and risks of calendar spreads

Benefits:

• Potential profit from time decay: the strategy aims to capitalise on the faster time decay of the near-term option compared to that of the longer-term option
• Defined risk: the maximum loss is typically limited to the initial net debit paid for the spread
• Flexibility in adjusting the positions: as market conditions change, you could – for example – select a different strike price for the contracts or roll the near-term option to a different expiration date
• Potential to profit, even in less volatile markets: the strategy can be profitable even if the underlying asset’s price doesn't move significantly, as long as it stays near the strike price
• Lower cost compared to outright option purchases: the sale of the near-term option partially offsets the cost of the longer-term option

Risks:

• Limited profit potential: maximum profit is typically capped and occurs when the underlying asset’s price is at the strike price on or before the near-term option’s expiration date
• Sensitivity to changes in implied volatility: a decrease in implied volatility could lead to greater losses, as the longer-term option you own will lose more value than the shorter-term option you sold. This is because longer-term options are more sensitive to changes in implied volatility
• Potential for early assignment: in the case of equity options, if the short option is in the money, there's a risk of early assignment. This can complicate the strategy
• Time-sensitive strategy: the effectiveness of the strategy depends largely on the timing of price movements relative to the options' expiration dates
• Complexity in execution: calendar spreads involve multiple options contracts with different expiration dates, which can be more complex to execute and manage than simpler options trading strategies

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