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Trading on Time Decay: How to Approach Calendar Spreads

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March 5, 2013
Calendar Spreads

This installment in our options-spread series tackles turning time decay into potential profit.

If you think there’s little trading opportunity in range-bound markets, think again. Opportunity sometimes burrows in the gaps between option-expiration dates. With a calendar spread, also known as a time or horizontal spread, you can potentially exploit time decay. Sounds a little like watching tomatoes rot on the vine. But it’s really about buyers and sellers putting value on that ripening fruit.

A calendar spread earns its name from option positions in two different expiration months that use the same strike and option kind (i.e. calls or puts), over two different months. You buy an option in one expiration month, and simultaneously sell another option in a different expiration month, with the same strike price as the first. You’re looking to profit from the difference in time decay between options with shorter expirations and those with longer expirations. Ideally, you’re potentially profiting from time decay in the short term, while keeping open the possibility of profit from a sharp directional move in the long term.

Calendar spreads, whether calls or puts, can maximize their value when the stock is at the strike price of the options, and the front-month option is expiring. As such, calendar spreads carry their minimum value when the stock is very far away from the strike price of the options. If you buy a calendar spread, you’re hoping for the stock price to be at the strike price at expiration. If you sell a calendar spread, you want the stock price to be as far away as possible from the strike price at expiration. The value of calendars will depend on the price of the underlying, the time to expiration, and the volatility of the individual options in the trade.

The Mechanics

For a long-call calendar spread, you sell a call in a near-term or front month at a certain strike, and buy a call in a longer-term, or deferred month, at the same strike. For a put-calendar spread, you sell a put in a front month at a certain strike, and buy a put in a deferred month at the same strike. A long calendar spread might be a good position if you think the stock price is going to move to, then stay at, a particular strike price until expiration of the front-month option.

For the purposes of this article we will focus on long-calendar spreads as they are “risk-defined”—meaning you know the worst-case scenario going in. That’s because the price paid for the calendar is the amount you can potentially lose (transaction costs and other fees will apply and must be considered in the total investment cost). The maximum risk of a long-calendar spread is the amount paid for it. The maximum value depends on the value of the deferred-month option when the front-month option expires.

A short call, or put-calendar spread, is simply the reverse of the long-calendar spread, using a long front-month contract, and short deferred-month contract. The difference? Short positioning is not risk-defined. One option in a calendar spread expires before the other, which is important to remember if you’re short the option further out on the calendar.

Enter The Greeks

When putting on a calendar spread, the ideal scenario is for the underlying to be at the strike price as close to expiration as possible. Any increase in volatility will also expand the calendar value on a long position, as it’s a positive vega position. Vega is another way to say volatility. At-the-money calendar spreads have the most value, as time decay (known as theta) is greatest near the price of the underlying. The farther you move away from the calendar strike, the more value the position loses.

Long Calendar Put and Call

FIGURE 1: The calendar spread will profit when the underlying stock settles within a certain range at the expiration of the short option. Bear in mind the wildcard is volatility. Should volatility increase, the profit curve will generally widen. Should it decrease, it will generally narrow. For illustrative purposes only.

Roll With It

Remember, calendars deliver ideally when the underlying stock is at or near the strike price in your spread, as close to expiration as possible. Consider, as a first risk, if your position moves away from the strike price. If you’re using multiple monthly calendars, you also have the opportunity to adjust or roll near-term options.

For example, you’re long June 50 calls in stock XYZ and short the March 50 calls in the same underlying. As you get closer to March options expiration, your short March 50 calls will lose value at a quicker pace than the further-term months due to greater time decay or theta. You could close out the entire position if it expands, or you could buy your short March 50 calls and sell a further-term month such as April. This would allow you to “roll” your short March 50 calls for a “credit.” Pocketing that credit reduces your total cost tied up in the option. The resulting position would be long your original June 50 calls in XYZ, and short the April 50 calls. Your price remaining, essentially your risk remaining, is the initial value you paid for the calendar, minus the credit received on the roll.

Other Risks

There’s more to think about. You may have to accept assignment of the short option, which will transform your calendar spread into another position. For example, a long-call spread has the risk of assignment on the short front-month call. If the short call is assigned, you will be short the corresponding number of stock shares in your account. If you’re assigned on five short calls, you would now be short 500 shares, as the options have a multiplier of 100. You must be aware, then, of the potentially significant risks due to assignment when you have short in-the-money options in any position.

Stretch Your Knowledge

Spreads (like the vertical variety we addressed in our inaugural series article), and the calendar, or time, strategy explored here, can give you agility in a range-bound market. That’s true if it’s used as a straight-up trade or as a hedge on another position. You’re also not necessarily locked into your spread. By simply closing out the short-term position, calendar spreads can easily be transformed into pure long-options positions if the underlying stock is expected to stage a breakout.

Don’t dismiss risks. But don’t dismiss spreads, either. The calendar may fly by. But you’ll know your potential risk from day one. And that’s appealing.