Trading Options by the Calendar: Time Can Be a Trader’s Friend

The calendar spread is one of the most common income generating trades. Perhaps it’s because calendars may be easily adjusted. Or maybe it’s because calendars are handy for trading quickly decaying weekly options. Regardless, the calendar is a strategy every trader should know.

Calendar trades are created by buying a longer-term, at-the-money (ATM) option and selling a shorter-term, ATM option with the same strike, using either all calls or all puts. Call calendars and put calendars are constructed virtually the same. For simplicity, we'll stick with call calendars in the following example.

An example of a call calendar could potentially look like this:

Buy the 60-day call for $3 and sell the 30-day option for $2, plus transaction costs, netting a calendar that's priced at only $1 and risks that same amount (the maximum risk for a calendar is the purchase price). 

Calendar profits come from the overall net effect of time decay, which affects all options. This basically means that options lose value as time passes. Time decay is quantified as an option's theta.

The theta of shorter-term ATM options is higher than that of longer-term ATM options. Because shorter-term options lose value faster, the difference in the rates of decay between the two offers a potential opportunity.

In this example, 30 days later with the stock right at the strike, the short June option has decayed more than the long July option, so the calendar generates a profit. How? The long option dropped $1 in value, which is a loss. But the short option decayed by $2, which is a profit. That nets out to a $1 profit. In percentage terms, the profit is 100%, less transaction costs, of the risk over a one-month time frame.

Using weekly options that expire every Friday can potentially increase that return:

Buying the three-week option for $1.65 and selling the two-week option for $1.25 creates a two-week calendar for a net price of only $0.40. The entry cost is less than half the cost of the first example using the monthly options. And look at how it could perform if the stock stays at the strike price for two weeks:

When the short strike expires, the long strike can be sold for a net credit of $0.80. That's a 200% return on the $0.40 purchase price. And since it took only half as much time as the monthly calendar, a trader could attempt to repeat the trade or move on to something else.

This is truly a situation where the sum of the parts is worth more than the whole—as long as the stock hangs around the strike price of the calendar. Of course, if it doesn't, then the calendar's value will drop and eventually go to zero. Still, the maximum risk is limited to the cost of the trade.

By exploiting the time decay curve, weekly options can not only provide trades with potentially better returns, but also the ability to possibly place multiple trades in the same time span that a monthly trade takes.