Trading Calendar Spreads: Learn the Strategy, Roll Decision, and Risks

The following, like all our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors.

If you’ve been trading options for a while, you’ve likely lived through one of those low-volatility, “watching-paint-dry” markets. Instead of twiddling those thumbs, consider putting them to work on an options strategy designed for such a market.

Option traders interested in premium collection strategies—those that are designed to profit from time decay (“theta”)—often turn to short strategies like iron condors or short verticals. These are considered “credit” trades because the premium is collected up front. They’re designed to profit if the underlying stock stays within a certain range through expiration but may not be successful if the underlying closes outside that range. 

But there’s a debit options strategy—where the premium is paid up front—that also aims to profit from theta. It’s called the calendar spread. The calendar spread strategy can be effective during times of low volatility and potentially useful if you think a stock or ETF will trend sideways in the near term. 

Interested? Here’s what you should know about managing calendar spreads, ideas on when calendar spreads may be useful, the potential profit and loss (P&L) points, and the risks.

Pitching a Tent (aka Setting Up a Calendar)

Calendars are created using any two options of the same stock, strike, and type (either two calls or two puts) but with different expiration dates. For example, if XYZ is $50, and you think it’ll trade in a tight range around $50 for a while, you might buy one July 50-strike call for $3 and sell one June 50-strike call for $2. You’d then be long a June/July calendar spread for a $1 debit plus transaction costs, which is also your maximum risk. 

How do you profit? If, as you expect, the shorter-term options decay at a faster rate than the longer-term options, the spread “widens,” and you may be able to close out the spread for a profit. All else being equal, if XYZ were to finish at $50 at expiration of the short options, your short options would be worth zero, and would likely expire unexercised, while the long options might be worth $2 at that point. Because your long spread has “widened” from $1 to $2, your profit, if you were able to sell to close that position, would be $1 minus transaction costs. It’s not always this perfect, but that is the idea.

The P&L graph looks something like a tent because maximum profits at the strike give way to lower profits sloping downward in both directions, eventually hitting break-even points before finally losing partial or full value (see figure 1). 

Now We’re Rolling

As expiration of that front leg nears, a decision needs to be made. Your short leg will soon expire, and if you do nothing before expiration, you could be left with half a spread. Plus, if your options are in the money (ITM) at expiration, are you prepared to either deliver the underlying or take a short position in it? An additional consideration is that fact that while the long call does make this a “covered” position, a trader would very likely surrender significant time value if they need to exercise the long option to cover the resulting short stock position due to assignment of the short option.

You might consider liquidating the entire spread by closing out both legs. But there’s another idea: rolling calendar spreads. The term “rolling” simply means moving options from where they’re now to somewhere else. That could be a different expiration date, a different strike, or both. 

When the short options in a calendar spread are nearing expiration, you might decide to roll them out to the same strike with another expiration date. This can be accomplished by buying your short options to close and selling to open the same strike on another expiration date. However, keep in mind, rolling to the same strike when your short option is ITM may reduce risk of early assignment, but it remains elevated in comparison with out-of-the-money (OTM) contracts. For this reason, a trader might consider rolling to an OTM strike to further reduce the probability of early assignment. Just make sure the expiration you roll to isn’t further out in time than your long options. Remember, the rationale of a calendar spread is positive theta—nearer-term options generally decay at a faster rate than longer-term options—so if your new short leg has more time until expiration than your long leg, this would likely be a negative-theta position.

Here’s an example using the theoretical options values from the table below. Let’s say you’re long the 50-strike call with 29 days until expiration and short the 50-strike call that expires in one day. A roll would involve buying the expiring options to close and selling another 50-strike call with options that have fewer than 29 days left until expiration. Because this roll involves selling options with more time to expiration than the options you’re buying to close, you should be able to roll for a credit. You also need to consider the transaction costs and margin requirements on the new position.

THE ROLL DECISION: WHICH OPTIONS? Weekly options allow flexibility in the roll decision. Weekly options positions are short-lived instruments that require close monitoring because they can be subject to significant volatility. Profits can disappear quickly and can even turn into losses with a very small movement of the underlying asset. For illustrative purposes only. 

Choosing a Strike

Which expiration you decide to roll to is up to you. There are no hard-and-fast rules, and like most options trading decisions, there are trade-offs. Options decay more quickly the closer you get to expiration; that’s the nature of theta. So you might choose to roll to the eight-day options. And assuming the underlying has stayed in a range near the 50 strike, you might be able to roll it again next week, and the next week, and so on. With weekly options, there’s an expiration on any given Friday. You might look to continue each week until you get to your long strike. At that point, you’ll likely want to liquidate both legs of the spread. Keep in mind, there’s no guarantee of a secondary (liquid) market for any option at any given time.

A potential issue with this strategy of rolling frequently is transaction costs. The more often you place a trade, the more often you’ll incur costs. So, you might instead decide to roll to the 22-day options. The premium, and thus the credit you’ll receive, is higher than it is for the eight-day options, but you won’t have as many opportunities to repeat the process before it’s time to liquidate the entire spread.

Other factors in your decision could include:

• Has the underlying strayed from your strike? If so, you might want to consider a different strike—theta is typically greatest in the at-the-money strike. But remember: Changing strikes will affect price expectations and may impact margin requirements as well.
• Is there an earnings release or other news pending on the underlying? This can mean higher implied volatility, which generally translates into a higher-than-normal price for short-term options but can also mean excessive price fluctuation right when you’re looking to roll the position. Some option traders like trading around earnings; others try to avoid it.  

The calendar spread strategy can be effective in times of low volatility and are potentially useful if you think the underlying might stay within a tight trading range in the near term. The mechanics of setting up and rolling calendar spreads might seem intimidating at first, but after you break them down into individual parts and individual decisions, you might consider giving this strategy the thumbs-up, especially during those low-volatility, thumb-twiddling markets.