Calendar Spreads or How to Trade Time
When dealing with options, almost anything is possible. In fact, options traders often talk in terms of buying and selling time. Unfortunately, they're probably talking about time premium, and so the search for the fountain of youth must continue! The trading of time premium is typically done using Calendar Spreads although you will also hear them referred to as Time Spreads or Horizontal Spreads. Actually for options on futures, some writers do differentiate between Calendar and Time Spreads, but for our purposes they are the same.
To get us all on the same page, let's start out with the definition.
Definition: A Calendar Spread is an options strategy in which an option is sold in a near term month and an option is purchased in a longer term month. The options are either both Puts or Calls and have the same strike price.
When you buy the far term and sell the near term options you are said to be long the Calendar Spread. The other side of the position, buying the near term and selling the far term options, is said to be short the Calendar Spread. Since the longer term option is almost always higher than the near month option, a long Calendar Spread is usually done for a debit, and we will go on this assumption for the rest of this article. You may want to think about what circumstances could lead to a situation where the near term option is more expensive than the far term option. HINT: it has to do with volatility skew and dividends.
Calendar Spreads are a very useful and common strategy. Most public traders trade this strategy from the long side for a number of reasons, the most important of which relates to the margin requirements. The short option in a long Calendar Spread is considered covered by the longer term option and therefore, no additional margin is required. However in the case of the short Calendar Spread, most brokers would not consider the short far term option to be covered by the long near term option and therefore would impose a margin requirement on this position.
What is the basic concept of the long Calendar Spread? The idea here is that both options, the short and the long, will decay over time. However, the near term option will decay at a faster rate than the long term option and if nothing else changes, the value of the spread will increase.
For example, with XYZ stock trading at $102, the theoretical value of the July 100 Call is $6.40 and the Sept 100 Call is $9.85. So it would cost us $345 to buy the XYZ July/Sept 100 Call Calendar Spread. As of today, there are 38 days left until July expiration and 101 days until Sept expiration. Let's assume we put on 10 spreads for a total debit of $3,450, ignoring commissions of course. If nothing else changes, namely; stock price, volatility, risk free interest rate or expected dividends, an admittedly big IF, the value of the spread will change in the following manner:
This shows that we would have made a nice profit of $2,510 as the value of the spread increased from $3,450 to $5,960 in 38 days. That's about a 72% nominal rate of return time on an initial investment of $3,450 (or almost 700% annualized) with a maximum risk of less than $3,450.
This profit was based on the stock staying at $102 through July expiration. Is that where we actually want it, or is there a better sweet spot? I can just run some numbers in my options calculator, but let's think about this. At expiration, if the stock increased to $103, then the value of the July 100 Call would be $3. Since the Sept 100 Call is slightly in the money, I would estimate that its delta is about 60%, so a $1 increase in the stock price ($102 to $103) would cause the Call to increase by 60 cents from $7.96 to $8.56. This would result in an estimated decrease in the value of the spread to $5,560. In a similar fashion I think it's clear that as the stock increases in value, the spread will decrease.
If you need more convincing, just assume that the stock increased tremendously to say $200. Again, looking at July expiration that Call will be worth exactly $100, while the Sept Call will have shed most of its time value and will probably be worth about $100.45, yielding a spread value of only $450.
On the other hand what if the stock went down $2 to finish right at the strike? Now the July Call will be worthless, and the Sept Call will be worth approximately $6.76, for a spread value of $6,760. Since we know that the Sept Call will continue to lose value as the stock heads south, and that the July Call is already at zero and can't decrease any further, the value of the spread will decline.
Again, take an extreme case of the stock falling to $50. The July Call is $0 and the Sept Call will also be very close to $0, for a spread value of near $0.
What about implied volatility, do we want it to go up or down at expiration of the near term option from the time that we put it on? The answer should be obvious. When we get to the near term expiration, that option will be either worthless or equal to parity. In other words it will not have a volatility component, and its value will not be dependent on volatility. The long far month option will have a volatility component and will increase if implied volatility increases. That is what we want to maximize the value of the spread.
So it seems like when we put a Calendar Spread on, we want the stock to not move very much, but for volatility to increase. This is a well known characteristic of Calendar Spreads and is referred to as the internal inconsistency of the Calendar Spread.
The question arises as to when and how do we put on a Calendar Spread. We want implied volatility to be low and have reason to believe that it will increase. If there's a reverse horizontal skew (higher implied volatility in the near month versus the far month) that will also help.
General guidelines suggest that the near month expiration be somewhere between 30 and 60 days, and that the far month expiration be from 1 to 3 months after that. The strike price should be where you expect the stock to be at expiration of the near term option.
And now for the $64,000 question; should you use Puts or Calls? The answer is; while there are some nuances regarding the impact of early exercise, and some other minor things, it really doesn't matter very much. The Put Calendar Spread and the Call Calendar Spread are synthetically equivalent to each other. Using a technique called pricing off the Jelly Roll (I kid you not), you can determine if there is an advantage to putting on the spread with Puts or Calls. That's something I reserve for my mentoring students.
You've probably noticed that I hardly made any mention of the Greeks this week. The idea was to show you how to reason things out just based on the knowledge you already have about options. The truth is however, that by using the Greeks it would have been a lot easier. I won't go through examining all of them, but I suggest that you do. It will be a good test of your understanding. For instance, regarding volatility, we know that the far term option (Put or Call) has a greater vega than a near term option. So the vega of the Calendar Spread will be positive. Hence, an increase in volatility is good, and a decrease is bad.
The Calendar Spread is extremely versatile and can be used in many different types of situations. I'll just mention a few variations to whet your appetite. They can be ratioed (sell 10, buy 9) to make the spreads delta or gamma neutral. If there is both a vertical and a horizontal skew, they can be diagonalized (sell July 100 Calls, buy Sept 105 Calls), or you can put on dual Calendar Spreads (one spread below the strike and one above.) There's lots to play with.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!