Introduction

Many tools in the options market help you earn profits by selling options before they reach expiration. Calendar spread is one such tool that seasoned traders vouch for. It is a low-risk strategy initiated when the market's direction is neutral.

What is a calendar spread?

A calendar spread strategy is used in the trading of options and futures. It is spread over a calendar month, and hence the name calendar spread. It is also known as counter spread, time spread, and horizontal spread.

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Calendar spreads can be of different types. It is called a calendar put spread if you use it for a put option. And if you use it for a call option, it is called a calendar call spread.

The objective of the spread trading strategy is to lock in profits from fluctuations in volatility over time. It rests on the idea that near-month options prices fluctuate more than far-month. Institutions and HNIs looking for low-risk strategies with the potential to earn large rupee returns based on volumes often use calendar spreads.

How does a calendar spread work?

A calendar spread works by buying and selling the same option with the same underlying asset. The strike price must be the same, but the expiration dates must differ.

The strategy trades on the gap between two similar contracts instead of betting on the price. It is typically initiated when the directional assumption of the underlying asset is neutral. Calendar spreads help earn money due to increased implied volatility or the passage of time.

You can also earn profits by being a little bullish or bearish. If you expect the market to be neutral but feel that the stock’s underlying price will rise, you can go for an out-of-the-money (OTM) call calendar. On the other hand, if you’re slightly bearish in a neutral market, you can choose an OTM put calendar.

Whether you go for the OTM put or call calendar, you will sell the nearest OTM put or call (short position) to collect more premium on the long option you’re buying. The strike price you choose on the long position that’s further out in time will be the same. The use of different strike prices will make it a diagonal spread instead of a calendar spread.

Additionally, if you anticipate minimal movement in the underlying asset's price, make at-the-money (ATM) options your choice. This is because the short option loses, and the long option gains or retains extrinsic value with time. The trade is purely extrinsic since both options are at equal strike prices, eliminating any intrinsic value if the spread moves in the money (ITM).

Illustration

Here’s a scenario to help you understand the calendar spread.

You believe the market sentiment will be neutral for the next two months, after which there will be high volatility. You go for a spread that has a five-month expiry date. Due to the time duration, the long-term call will be costly. You can enter a spread to offset the expenses. This means you sell one short-term and buy one long-term at a premium of Rs. 35.

• Short-term call - Rs. 2560
• Long-term call - Rs. 2560
• Premium paid - Rs. 35
• Long-term cost without spread - Rs. 75

Situation 1: The market experiences a downfall. The short-term call expires without a profit or loss, but you retain the premium. Your loss is limited to Rs. 35, less than Rs. 75, the call’s long-term cost without a spread.

Situation 2: The market rallies to 3100. The cost of the short-term call becomes Rs. 540. The spread value equals zero. In this scenario, you can only maximise the profit by buying the long-term call.

Situation 3: There is no movement in the market. The long-term call remains at the money while the spread expires as worthless. You will earn a profit calculated by subtracting the premium paid from the ATM long-standing call.

To sum it up

A calendar spread is defined as the simultaneous buying and selling of two calls or puts on the same underlying asset and price for different maturity. This strategy makes payoffs on the calendar spread depend on the spread’s rise or fall. If you speculate the spread to rally upwards, you go long on the calendar spread, but if you think the spread will decline, you go short on the calendar spread. A calendar spread is initiated when the market is expected to be neutral, which makes it ideal for stable markets.

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