Calendar spread

A calendar spread, also known as a time spread, is an options strategy that involves buying and selling options of the same stock with different expiration dates. The strategy involves the purchase of an option with a near-term expiration date and the sale of an option with a further expiration date. By entering this spread, the trader hopes to benefit from the difference in the premiums of the two options, as the near-term option will typically be more expensive than the further-term option. The purchase of the near-term option is referred to as the long leg of the spread and the sale of the further-term option is referred to as the short leg.

Calendar spreads can be used to take advantage of expected movement in the underlying stock, as well as to make profits through the premium differences between the two options. The maximum profit potential is typically limited to the difference in the premiums of the options, while the maximum loss is typically limited to the net premium paid for the spread.

Example of Calendar spread

A calendar spread can be created by buying an option with an expiration date of 30 days and selling an option with an expiration date of 60 days. The purchase of the near-term option is referred to as the long leg of the spread and the sale of the further-term option is referred to as the short leg. The maximum profit potential for this spread is the difference in the premiums of the two options, minus the cost of the spread. The maximum loss is the net premium paid for the spread.

Formula of Calendar spread

The formula for calculating a calendar spread is:

$Calendar\ Spread\ Profit=([[Price]]\ of\ Long\ Option-Price\ of\ Short\ Option)-Net\ Premium$

Where the price of the long option is the purchase price of the near-term option, the price of the short option is the sale price of the further-term option, and the net premium is the total cost of the spread. This formula can be used to calculate the maximum profit potential of a calendar spread, as well as the potential loss from entering the spread.

When to use Calendar spread

Calendar spreads are most commonly used when the trader expects the underlying stock to remain at or near its current price for the duration of the spread. This strategy will not benefit as much from a large move in the stock, so this spread is often used when the trader expects the stock to remain relatively stable. *This strategy is also used when the trader wants to collect the difference in the premiums of the two options and is willing to give up the potential large gains from a large move in the stock.*

In addition, calendar spreads can be used to reduce the cost of purchasing long-term options, as the short-term option typically has a higher premium than the long-term option. This can be beneficial for an investor who is looking to purchase a long-term option but does not want to pay the full premium.

Types of Calendar spread

Calendar spreads can be classified into two main categories: bullish and bearish spreads.

• Bullish Calendar Spreads: Bullish calendar spreads involve the purchase of a near-term option and the sale of a further-term option. The maximum profit potential is typically limited to the difference in the premiums of the options, while the maximum loss is typically limited to the net premium paid for the spread.
• Bearish Calendar Spreads: Bearish calendar spreads involve the sale of a near-term option and the purchase of a further-term option. The maximum profit potential is typically limited to the difference in the premiums of the options, while the maximum loss is typically limited to the difference between the strike prices of the two options minus the net premium received for the spread.

Steps of Calendar spread

Calendar spreads can be created in several ways, but the most common method involves the following steps:

• Step 1: Buy an option with a near-term expiration date. This purchase is referred to as the long leg of the spread.
• Step 2: Sell an option with a further expiration date. This sale is referred to as the short leg of the spread.
• Step 3: The trader hopes to benefit from the difference in the premiums of the two options, as well as to make profits through the expected movement in the underlying stock.

Advantages of Calendar spread

The key advantages of a calendar spread include:

• Reduced Risk: When compared to buying or selling a single option, calendar spreads can offer reduced risk because the maximum loss is limited to the net premium paid for the spread.
• Leverage: Calendar spreads offer traders the ability to use leverage, as less capital is required to enter the spread compared to buying a single option.
• Time Decay: Calendar spreads enable traders to take advantage of time decay, as the time value component of the option that is sold will decay faster than the time value component of the option that is bought.

Limitations of Calendar spread

A calendar spread has a few limitations that traders should be aware of.

• First, the maximum profit potential is typically limited to the difference in the premiums of the two options, as the spread will need to expire worthless for the trader to realize this profit.
• Second, the maximum loss is limited to the net premium paid for the spread.
• Third, calendar spreads can be affected by volatility, meaning that the spread may not perform as expected if the implied volatility of the options changes. Finally, the trader should be aware that the spread will need to expire worthless for the trader to realize the maximum profit potential.

Other approaches related to Calendar spread

A Calendar Spread can also be used with other approaches, such as buying a call option while selling a put option with the same expiration date, or buying a call option and buying a put option with different expiration dates. *In the case of buying a call and selling a put with the same expiration date, the trader is hoping to benefit from a directional move in the underlying stock, while in the case of buying a call and buying a put with different expiration dates, the trader is hoping to benefit from an increase in implied volatility in the underlying stock.*

In conclusion, a Calendar Spread can also be used with other approaches, such as buying a call option while selling a put option with the same expiration date, or buying a call option and buying a put option with different expiration dates. The trader can benefit from a directional move in the underlying stock or an increase in implied volatility in the underlying stock.

Calendar spread — recommended articles

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References

• Schneider, L., & Tavin, B. (2018). From the Samuelson volatility effect to a Samuelson correlation effect: An analysis of crude oil calendar spread options. Journal of Banking & Finance, 95, 185-202.
• Laurenti, M., & Fernandes, J. M. M. (2012). Pricing crude oil calendar spread option. Master’s Degree Thesis, Department of Finance, Copenhagen Business School.
• Hainaut, D. (2018). Calendar spread exchange options pricing with Gaussian random fields. Risks, 6(3), 77.