The market has been very choppy and with implied volatility still relatively low, it has been difficult for credit spread traders to find opportunities. A calendar spread, or what it is sometimes referred to as a time spread or horizontal spread can be a simple and quite useful option strategy. The calendar spread is designed to work somewhat like a covered call but without the potentially huge outlay of cash that can accompany buying shares of stock. The spread profits from time decay (option theta) and can make money in any direction depending on the strikes that are chosen. The spread can be set-up with a bullish, bearish or neutral outlook on the underlying either using call options or put options.
How to Create a Calendar Spread
Creating a calendar spread involves buying and selling options on the same underlying with the same strikes but different expirations. The best case-scenario is for the stock to finish at the strike price allowing the short-term option to expire worthless and still have the long option retain much of its value.
For the sake of this example, close to at-the-money (ATM) options will be used but out-of-the-money (OTM) and in-the-money (ITM) options can also be used depending if there is a bullish or bearish bias. As a general guideline, if I have a bullish outlook on the underlying I use call options and put options for a bearish bias. The reasoning is that OTM options generally have tighter bid/ask spreads than options that are currently trading ITM. Initially being down less money entering any option trade due to a tighter bid/ask spread is always a good thing.
Simple to Follow Example
At the beginning of June, Halliburton Co. (HAL) was trading just over $46. The stock has been slowly rising and falling over the last year. The trader forecasts that the stock will still be about the same price or maybe a tad lower by June expiration because of the 50-day simple moving average which is in the area and might act as a magnet. This scenario makes it worthwhile to look at a calendar spread. HAL has June and July expiration’s available. The trader can buy the July 46 call for 1.80 and sell the June 46 call for 1.20. The total cost of the calendar spread is 0.60 (1.80 – 1.20) and that also represents the most that can be lost.
If the stock remains relatively flat as June expiration approaches, the calendar spread’s value should increase. Hypothetically, with about a week left until June expiration the July 46 call might be worth 1.30 and the June 46 call might drop to 0.35. The spread now would be 0.95. A profit could now be made of $0.35 (0.95 – 0.60). That doesn’t sound like much but a $0.35 profit on a $0.60 investment in a couple of weeks is not a bad return in my opinion.
The whole key to the success of the calendar spread is the stock must not have huge price swings. If the stock falls more than anticipated, the spread’s value will decline along with the stock. If the stock rises well above $46, the short June 46 call will partially or fully offset the increase in the long July 46 call depending on how much the stock rises.
There are other factors that can affect a calendar spread like implied volatility skews that can both help and hurt the spread. It is advantageous for the implied volatility to be higher for the short option versus the long option. This way the more expensive premium is sold and the cheaper is purchased. This component will be discussed in greater detail at a later time.
The beauty of the calendar spread is that it almost functions like a credit spread without the added risk. The risk with a credit spread is that it may suffer a substantially greater loss than a calendar spread if the stock moves in the opposite direction of the outlook due to high risk and low reward scenario that accompanies most out-of-the-money (OTM) credit spreads.
Senior Options Instructor