Here's a question: What do you get when you cross time passing with a dull market? Nothing.
And that’s the point of a long calendar spread—much ado about nothing. Well, almost. While traditionally, the calendar spread is a strategy designed to profit when the market doesn’t move very much, it can be as much a bullish or bearish strategy as a neutral one. And when market conditions suggest low volatility (“vol”), it can be potentially the ideal pick.
As pros know, calendar spreads in spirit only care about extrinsic (time) value. And because a calendar spread is made up of either calls or puts, in different expirations at the same strike price, if one option is in the money (ITM), the other is, too, by the same amount. In fact, any intrinsic value for the calendar’s short option is offset by the same amount of the long option’s intrinsic value. But the extrinsic values of the options are in fact different. So only extrinsic values matter when considering the value of calendar spreads. And it’s this extrinsic value that’s most influenced by volatility.
FIGURE 1: LONG CALENDAR SPREAD The top peak of a calendar spread risk curve is
the strike at which you place the trade, which can be at, above, or below the stock price,
depending on where you think it will go. For illustrative purposes only.
Peas In Pods
A calendar’s debit is the price of the option you’re buying (i.e., June 100 put), minus the price of the option you’re selling (i.e., May 100 put), plus transaction costs. The max potential loss on a long calendar spread is the debit you pay.
You may see more calendar opportunities with low vol because their debits tend to be lower. The more time to expiration, the higher an option’s vega. For example, the June 100 put will have a higher vega than the May 100 put. When vol goes up, the June put’s extrinsic value increases more than the May put, which increases the calendar’s debit. When vol is lower, the June put’s extrinsic value decreases more than the May put, which decreases the calendar’s debit. And when the calendar’s debit is lower, its maximum risk is lower.
Using this May/June calendar as an example, if you pay $0.80 debit for the spread, the max loss is $80, plus transaction costs. That occurs at the expiration of the near-term short option, when the stock is higher or lower than the calendar’s strike price, and the extrinsic value of the options is low or zero. Let’s review a long May/June 100 put calendar for an 0.80 debit.
The further the option moves away from the stock price, the lower the extrinsic value. That’s true for both in and out-of-the-money (OTM) options. If the stock is at $150 at May expiration, the short May 100 put will expire worthless, and the long June put will be far OTM. It may have a low extrinsic value, say, 0.10, and the calendar is worth 0.10 at that point (losing trade). If you hold it through June expiration, and the stock is above $100, the June 100 put will expire worthless, and the calendar will have a max loss of 0.80.
If the stock is at $50 at May expiration, the short May 100 put will be deep ITM, and worth its $50 intrinsic value. The long June 100 put will be deep ITM, too, and also have $50 intrinsic value. The June 100 put might have some extrinsic value. As with the stock at $150, the calendar’s value would be the extrinsic value of the June 100 put. If the extrinsic of that June put is 0.10, the calendar would be worth 0.10.
In both cases, with the stock at $150 and $50, the extrinsic values of the options are low, which makes the calendar’s value low. If its value is less than the debit you paid, it’s a loser.
Consider the Gap
Calendar spreads have the largest value when the difference between the extrinsic values of the long and short options is the highest. For any given expiration, the at-the-money (ATM) options have the highest extrinsic value, and the option with more time to expiration (the long June 100 put) will have a higher extrinsic value than the option with less time (the short May 100 put).
When the stock price is at $100 at expiration, the 100 strike is ATM. The May 100 put will have zero extrinsic value because it’s expiring, and the June 100 put will have more value. That makes the difference in extrinsic values (high vs. zero) higher—making the value of the calendar higher, too.
A calendar is profitable, then, when its value is greater than the debit you paid. And its max value (and max profit) happens at the expiration of the short front-month option, with the stock exactly at the calendar’s strike price. This makes the short option’s extrinsic value zero, and maximizes the long option’s extrinsic value.
What's It All Worth?
How high can the calendar price rise? We can guess. As implied vol moves up and down, extrinsic values of options do, too. If vol is lower when the stock is near the calendar’s expiration strike, the calendar will be worth less, because the long option’s extrinsic value is also lower.
Even if the stock is at the calendar’s strike price at expiration, its value might be lower than the debit paid. If vol is higher when the stock is near the calendar’s strike at expiration, the calendar will be worth more, making the potential profit larger. Because vol can go higher and lower independently, in different expirations, and we can’t pinpoint when, the max calendar spread profit is always an approximation.
What Every Pro Should Know
Even the most veteran traders have inquiring minds. They take nothing for granted. But here are a couple of nuggets even the pros may not be thinking about.
The Question of Direction
A good place to start—are calendars bullish, bearish, or neutral? While most learn them as market-neutral, they can be all three. Simply buy the calendar at the expected strike point— better yet, the middle of an expected range.
• If you’re bullish, buy a call calendar with a strike higher than the prevailing stock price.
• If bearish, buy a put calendar at a lower strike price.
• If neutral, buy a calendar at a strike that’s close to the prevailing stock price. Naturally, it’s hard to know when to use a calendar as a directional trade.
Rolling Your Losers
So, what’s your calendar management strategy once you have one on? If the stock is close to the strike in the last week before expiration, and the calendar has a profit, consider taking whatever profits you have, even if the calendar might still expand in value at expiration. The stock might move away from the strike price and turn the profitable calendar into a loser. With less time to expiration, the stock price might not come back to the strike.
If the calendar is a losing trade, but you believe the stock could still go to the short calendar strike in the future, consider rolling the short option to the next expiration (in a multi-month calendar), when the short option has little extrinsic value left, and can’t deliver additional profit.
Yet, if the calendar is OTM, you can let it go through expiration, and keep the long back-month option as a speculative directional trade. If the calendar is ITM, close the trade before expiration to avoid the short option’s assignment.