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Calendar spread

In a neutral market, the calendar spread provides a method for the trader to earn income by profiting from time decay. This is achieved without the risk of an uncovered sold position. The strategy consists of writing a shorter term call option and taking a longer term call option with the same strike price.

When to use
Market outlook neutral to first expiry
Volatility outlook steady to first expiry

Payoff diagram

calendar spread payoff diagram

The calendar spread
Construction short call X, near-term expiry, long call X, far-term expiry
Point of entry market around strike price
Breakeven at expiry undetermined in advance
Maximum profit at expiry undetermined but limited
Maximum loss at expiry limited to cost of spread
Time decay helps
Margins to be paid? maybe

Profits and losses

Since the calendar spread involves two expiry months, it is not possible to construct an accurate payoff diagram for the strategy at expiry of the sold option. The value of the long option at this point can only be estimated using pricing models. However, the maximum profit will be realised if the share price is at the strike price of the options at the first expiry. The sold call will then expire worthless, while the long call will have the most possible time value remaining.

The calendar spread benefits from the different rate of time decay of the two options involved. Time decay of the near month option's premium will be faster than that of the far month option. This has the effect of widening the spread between the two prices. 

The maximum loss possible is the cost of the spread. This will occur if the long call has very little time value left at expiry, in other words if the share price has either risen or fallen dramatically.

Other considerations

  • Exercise: if the share price rises, both legs will come into-the-money. In this case, the trader faces the possibility of early exercise on the short leg. The long leg acts as a hedge, but the cost and inconvenience of being exercised must be considered.
  • Buying stock cheaply: the calendar spread can be used as a way of acquiring stock below the current market price. If an investor expects the share price to rise, but does not foresee this taking place within the next month, buying a calendar spread effectively gives the investor a call option once the near month expiry has passed, however at a lower cost than taking a call outright.
  • Volatility: an increase in short term volatility can be damaging to the calendar spread, since it works against the desired fall in value of the sold call option.

Follow-up action 

If the market remains steady, the investor may choose to do nothing and let time decay take its course, resulting in the short call expiring worthless. The investor can then close out the long call or perhaps hold on to it if expectations are now bullish. Holding the call converts the strategy to a simple taken option position, with the attendant risks and rewards. 

If the stock falls unexpectedly, the investor may choose to close the spread before the long call loses all time value. Otherwise, the position could be left in the hope that the market recovers and the long call improves in value. 

In the event of a market rise, the investor must decide whether to close out the spread to avoid exercise or maintain it in the hope that the market retreats and time decay can take effect.

  • Take advantage of time decay by entering the spread around six weeks before expiry of the near-term option.
  • Be wary of leaving the taken call open after expiry of the sold option. If this is the case then the position becomes a different strategy.

Example

You believe that shares in ABC Limited are likely to remain stable for at least two months, and wish to earn some extra income during this period. However, you are not prepared to expose yourself to the risks involved in writing an uncovered option. You decide to enter a calendar spread.

Sell 1 Dec $4.00 Call @ $0.22 and 
Buy 1 Mar $4.00 Call @ $0.38

calendar spread payoff diagram

Disclaimer
The information contained in this webpage is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.

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