Calendar Spreads in Futures and Options Trading Explained

What Is a Calendar Spread?

A calendar spread is an options or futures strategy where an investor simultaneously enters long and short positions on the same underlying asset but with different delivery dates.

In a typical calendar spread, you would buy a longer-term contract and go short with a nearer-term option with the same strike price. If two different strike prices are used for each month, it is known as a diagonal spread. Calendar spreads are also called inter-delivery, intra-market, time, or horizontal spreads.

Essentially, a calendar spread involves a dual wager on a security’s price and volatility across different points in time. Rather than solely predicting whether an underlying asset like a stock will rise or fall, it profits from the passage of time itself.

The mechanics involve simultaneously buying and selling options on the same underlying asset but with different expiration dates. Typically, an investor sells a shorter-term option while purchasing a longer-dated one with the same strike price (the price at which the option can be exercised).

Calendar spreads aim to generate profit when an asset’s price remains relatively stable. The option sold first will decay in value more quickly because of its closer expiration, hopefully offsetting the cost of the longer-dated option purchase. In addition, the strategy aims to capture changes in “implied volatility,” a factor often tied to the uncertainty that affects option premiums.

Understanding Calendar Spreads

Before getting underway, let’s give you a cheat sheet for some key terms.

• Call option: A contract giving the buyer the right, but not the obligation, to purchase an underlying asset at a set price, called the strike price, by a specific date, called the expiration.
• Put option: A contract allowing the buyer the right to sell an underlying asset at a strike price before the expiration date.
• Long position: Holding an option you bought means you are “long” in that option.
• Short position: Selling an option contract you don’t yet own creates a “short” position.

The typical calendar spread trade involves the sale of an option (either a call or put) with a near-term expiration date and simultaneously buying an option (call or put) with a longer-term expiration. Both options are of the same type and typically use the same strike price. Let’s break this down:

• Sell near-term put/call
• Buy longer-term put/call
• It’s preferable but not necessary that its implied volatility is low.

A reverse calendar spread takes the opposite position and involves buying a short-term option and selling a longer-term option on the same underlying security. Investors executing a reverse calendar spread buy a near-term option and at the same time sell a longer-dated option on the same underlying asset and at the same price.

This reversal hints at the difference in expectations. A reverse calendar spread generally anticipates a significant move (up or down) in the underlying asset’s price. It can also aim to profit from an expected spike in implied volatility, which could boost the value of options even without a large change in the underlying asset itself.

Crucially, the purchased near-term option needs to surge in value sufficiently to surpass the slower decay of the option sold further out in time. Timing and the magnitude of the anticipated move are thus key factors in a reverse calendar spread’s success.

Executing the Calendar Spread

The calendar spread strategy aims to profit from the passage of time or an increase in implied volatility in a directionally neutral strategy.

For a regular calendar spread, since the goal is to profit from time and volatility, the strike price should be as near as possible to the underlying asset’s price. The trade takes advantage of how near- and long-dated options act when time and volatility change. An increase in implied volatility, all other things being equal, would positively impact this strategy because longer-term options are more sensitive to changes in volatility (that is, it has a higher vega). The caveat is that the two options can and probably will trade at different implied volatilities.

The passage of time, all else being equal, would positively affect this strategy at the beginning of the trade until the short-term option expires. After that, the strategy is only a long call whose value erodes as time elapses. In general, an option’s rate of time decay (its theta) increases as its expiration draws nearer.

Maximum Risk and Profit on a Calendar Spread

For a debit spread, the maximum loss is the amount paid for the strategy. The option sold is closer to its expiration and, therefore, has a lower price than the option bought, yielding a net debit or cost. The ideal would be a steady to slightly declining underlying asset price during the life of the near-term option, followed by a strong move higher during the life of the far-term option or a sharp increase in implied volatility.

At the expiration of the near-term option, the maximum gain comes when the underlying asset is at or slightly below the strike price of the expiring option. If the asset is above that, the expiring option would have intrinsic value. Once the near-term option expires as worthless, the trader is left with a simple long call position, which has no limit on its potential profit. A trader with a bullish longer-term outlook can reduce the cost of purchasing a longer-term call option.

Here are different ways to employ the strategy, including regular and reverse calendar spreads:

• Long call calendar spread: You buy a longer-term call option and sell a shorter-term call option at the same strike price. This is a wager on a moderate price increase or rising volatility in the underlying asset price.
• Short call calendar spread: You sell a longer-term call option and buy a shorter-dated one at the same strike price. Profits would come if there’s a stable price or decreasing volatility for the underlying asset.
• Long put calendar spread: You buy a longer-term put and sell a near-term put option, both at the same strike price. This strategy anticipates a moderate drop in price or a volatility increase in the underlying asset price.
• Short put calendar spread: You sell a longer-term put option and buy a shorter-term put with the same strike price. Profits come from a stable or increasing underlying asset price or falling volatility.

Note that long spreads usually have a set maximum loss, while short spreads carry greater risk should the underlying asset move sharply against the position. We put this in a chart below. (All spreads require the same option strike prices.)

Difference in Using American- vs. European-Style Options

Regarding index options and the possibility of early exercise, it is essential to differentiate between American- and European-style options. This characteristic of European-style options means the risk of early assignment is eliminated, so the maximum loss is the initial premium paid, barring any unusual circumstances.

However, when dealing with American-style options, the possibility of early exercise requires another consideration in a calendar spread. The primary effect of early exercise on a calendar spread and its maximum loss relates to the short leg of the spread, as the holder of the option that the trader wrote or shorted might decide to exercise the right to buy or sell, depending on whether the option is a call or put. The trader must fulfill the terms of the option contract. Thus, the original calendar spread would no longer exist, which changes the maximum loss. Hence, the early exercise of American-style options adds a layer of risk that requires more active management. Traders would need to adjust their positions to mitigate potential losses.

Pros and Cons of Calendar Spreads

Calendar spreads have advantages and disadvantages, making them suitable for certain market conditions and strategies while posing risks for others.

Advantages

• Income generation: Calendar spreads can generate income from the premium collected on the short option. This strategy can be particularly good in a sideways or range-bound market, which is when the underlying asset price doesn’t change much.
• Flexibility: There is flexibility to trade based on expectations of volatility and time decay. You can capitalize on the accelerated time decay of the near-term option relative to the longer-term option.
• Limited risk: The maximum loss is limited in the long call and long put calendar spreads to the net premium paid for the spread. This predefined risk for the long call and long put calendar spreads makes managing the potential downside easier.
• Managing volatility with time: This spread is ideal for when you expect an increase in volatility, but not right away. The value of the longer-dated option can increase with a rise in implied volatility, potentially leading to profits.
  

Disadvantages

• Limited profit potential: While the risk can be limited for long call and long put calendar spreads, so are the profits for short call and short put calendar spreads.
• Complexity: Managing calendar spreads requires a good understanding of options, including how time decay and changes in volatility affect option prices. This complexity can make it challenging for less experienced traders.
• Cost and execution risks: The strategy involves several transactions, which means more transaction costs. Execution risk is also a factor; misalignment in executing the two legs can modify the intended position.
• Impact of dividends and interest rates: Unexpected dividends can affect the optimal strike price and profit for equity options. Interest rate changes can also impact the cost of the options, especially for the longer-term options in the spread.

Calendar spreads are good for traders looking to profit from time decay and volatility differences between short- and long-term options. However, the strategy requires careful management and an understanding of options, and its effectiveness can be influenced by transaction costs, execution risks, and changes in the market, such as from dividends and interest rates.

Example of a Calendar Spread

Suppose that Exxon Mobil (XOM) stock is trading at $89.05 in mid-January. You can do the following calendar spread:

• Sell the February 89 call for $0.97 ($97 for one contract)
• Buy the March 89 call for $2.22 ($222 for one contract)

The net cost of the spread is thus: 2.22 - 0.97 = $1.25, or $125 for one spread.

This calendar spread will pay the most if XOM shares remain relatively flat until the February options expire, allowing you to collect the premium for the option that was sold. Then, if the stock increases between then and the March expiry, the second leg will profit. The ideal would be for the price to become more volatile in the near term but to generally rise, closing just below 95 at the February expiration. This allows the February option to expire as worthless while still allowing you to profit from increases in the price until the March expiration.

Since this is a debit spread, the maximum loss is the amount paid for the strategy. The option sold is closer to expiration and thus has a lower price than the option bought, yielding a net debit. In this case, you hope to capture gains from a rising price (up to but not beyond $95) between the purchase and the February expiration.

If you were to simply buy the March expiration, the cost would have been $222, but by employing this spread, the cost is only $125, resulting in less risk. Depending on the strike price and contract type, the strategy can be used to profit from neutral, bullish, or bearish market trends.

The Bottom Line

Calendar spreads in futures and options trading are highly sophisticated strategies that cater to traders who leverage differences in time decay and volatility between contracts with different expiration dates. A calendar spread involves the simultaneous purchase and sale of options of the same type and strike price but with varying expirations, capitalizing on the accelerated decay of the near-term option relative to the longer-term option.

These strategies can effectively help to mitigate risk, reduce the cost of the spread, and offer some income through premiums. However, their success demands in-depth knowledge of volatility, interest rates, and risk management, making calendar spreads a potent yet complex tool for experienced traders aiming to navigate short-term price moves or prepare for long-term shifts in the market.

Correction—July 27, 2024: This article was corrected to properly state the definitions for a short call calendar spread and a short put calendar spread.