Calendar Spread: All you should know

A calendar spread is among the highly rewarding options trading strategies. Where most options trading strategies involve buying or selling options contracts with the same expiration date, this strategy involves selling and buying options with a different expiration date. Moreover, this strategy seeks to take advantage of implied volatility instead of capitalizing on favorable price movement. 

A calendar spread also promises limited loss potential but also limits your profit potential. If you want to know all about this strategy then you are on the right platform. In this article, we are going to explain it in the easiest words to enable you to understand it with ease. So, let’s begin right away. 

Calendar spread definition

A calendar spread strategy, also known as the horizontal spread, involves buying a longer-dated option while simultaneously selling a shorter-dated option. Traders can use both calls or put options to execute this strategy. Moreover, the strike price and expiration date must be the same but with a different expiration date. 

Explanation

Calendar spread differs from various other options trading strategies. Although it also involves buying and selling call or put options of the same underlying security and strike price but with a different expiration date. Additionally, it involves buying a longer-dated option while selling a near-term expiration date. In simplest words, the rule is to sell lesser expiration date options and buy long expiration date options. 

How does the calendar spread options trading strategy work? Implied volatility and time decay are at the very heart of this strategy. Traders looking to use this strategy first anticipate various volatility levels of the underlying security at different time periods. The point is to take advantage of the forecasted differences between volatility and time transit. Now, how does this strategy limit risk?

The concept of time decay is very crucial here. As you know, time decay accelerates as the expiration date approaches. That means short-dated option contracts lose more value because their expiration date is near. Contrarily, longer-dated options lose less value because their expiration isn’t near. Thus, the trader makes a profit when the spot price is near the strike price when the first expiration date approaches. 

Calendar spread types

As you know, traders can construct the calendar spread setup using both call and put options. 

Call calendar spread

The call calendar spread strategy involves buying long-call options and simultaneously buying short-call options. The objective of the strategy is to open positions on call options with a short call with an earlier expiration date and a long call with a longer expiration date. Although expiration dates differ, the underlying security and the strike price must be the same.

Put calendar spread

The put calendar spread strategy is similar to the call calendar spread but with put options. It involves buying long put options and simultaneously buying short put options. Again, the objective of the strategy is to open positions on put options with a short put with an earlier expiration date and a long put with a longer expiration date. The underlying security and the strike price must be the same while executing this strategy. 

Diagonal calendar spread

The diagonal calendar spread strategy involves buying and selling call or put options with the same underlying security and expiration date but different strike prices. Typically, it involves entering a position for a month. The logic behind this strategy is to capitalize on neutrality or slightly bearish sentiment of the market for the short germ.

Double calendar spread

A double calendar spread involves buying a call and a put option with an expiration date in future months. Whereas, selling near-month call and put options with the same strike price. 

Reverse calendar spread

Reverse calendar spread involves selling longer-term options while buying short-term options with the same underlying security. 

The secret of this strategy

Calendar spreads are among the highly popular option trading strategies. Although they offer capped or limited profit potential, they are good strategies for limiting loss potential. Furthermore, these strategies make money for you by capitalizing on time decay and implied volatility. How so? Let’s see.

The purpose of entering long and short positions is to benefit from price differences. As you know, short-term options lose value more rapidly than longer-dated options. Thus, traders make money from the difference between prices at the first expiration. Secondly, an increase in volatility in longer-dated options and a decrease in volatility in short-dated options make money for traders.

The wrap-up

The calendar spreads is one of the best strategies for options trading. However, it is important to note that these strategies work best during neutral market conditions. Traders use this strategy when they expect sideways movement in the short term. Understanding these strategies is very crucial but when to execute these strategies is even more important. If prices move significantly in either direction, you may suffer huge losses. Therefore, it is important to fully understand these strategies first to make money and avoid losses.