Calendar Spreads

The calendar spread, also known as a time spread or a horizontal spread, consists of option contracts based on the same underlying asset and the same strike prices but with different expiration dates, to exploit the differences in time decay, since the time value of options with sooner expiration dates decays faster than those with later expiration dates. A calendar spread is the purchase of a call or put for one expiration month along with the sale of a call or put with a different, usually earlier expiration month. A long calendar spread is short the option with the earlier expiration month, sometimes called the front month, and long on the later expiration month, sometimes called the back month; a short calendar spread is the reverse, so it is often called, naturally enough, a reverse calendar spread, or a reverse time spread.

Like butterflies and condors, calendar spreads have a limited-reward/limited-risk profile. A long calendar spread profits from a directionless market, i.e., one that is range bound. A short calendar spread profits from either a bull or a bear market, but will lose in a directionless market.

In analyzing profit and loss for calendar spreads, the following discussion assumes that the spread is closed out on the last trading day of the near option. Of course, it doesn't have to be closed out, or it could, as it often is, closed out earlier, but this assumption simplifies the discussion and isolates the value of the calendar spread, because otherwise a naked option will be long or short after the expiration of the near option, in which case it is no longer a spread. However, the far option can be used as part of another spread instead of being offset, but then it is just another spread which can be analyzed just like the original spread.

Unlike vertical spreads, butterflies and condors, maximum profit, breakeven points, or maximum loss cannot be calculated when the spread is set up because the time value of the unexpired option when the near option expires can only be estimated. The maximum profit for a long calendar spread is usually earned when the underlying price equals the strike price at expiration of the near, short option. Although a debit was paid for the spread, the remaining long calendar option will usually have significant time value, in which case it can be sold to earn the profit. The problem with calendar spreads is that the value of the remaining option is not knowable when the spread is set up, because the time value will depend on volatility, which, in turn, may be significantly influenced by important events occurring before expiration of the long option, such as an earnings report. Even without significant events, volatility will vary. In any case, only the time value of the far option will determine the value of the calendar spread. If the options are out of the money, then they will not have any intrinsic value; if they are in the money, then the intrinsic value of the short option will offset the intrinsic value of the long option.

Long Calendar Profit/Loss = Time Value of Far, Long Option − Debit

Short Calendar Profit/Loss = Credit − Time Value of Far, Short Option

To understand the profit and loss potential of a calendar spread, understand what affects the time value of the option. The option premium consists of both a time value + any intrinsic value, which is the amount by which the option is in the money. When an option is out of the money, then the option premium consists entirely of time value. However, the time value quickly declines to 0 as the option moves more out-of-the-money. On the other hand, an option that is well into the money also has little time value, because the option premium depends more on the intrinsic value. Especially for out-of-the-money options, time value will be proportional to the amount of time remaining until expiration, since a longer time increases the probability that the option can finish in the money.

The profit or loss of a calendar spread will depend on the time value of the component options. Time value, in turn, depends on the volatility of the underlying asset, which will affect supply and demand, which is the ultimate price setter. Intrinsic value, on the other hand, will always be determined by the difference in the price of the underlying and the strike price; intrinsic value will never be less than that because arbitrageurs will keep trading the stock and the option until the intrinsic value at least equals the difference between the price of the underlying and the strike price of the option. For this reason, there is some risk in a calendar spread that is not present in a vertical spread, because in a vertical spread, all the options expire in the same month, so potential profits and losses can be calculated from the strike prices and the price of the underlying. Of course, traders try to estimate what the time value of the back month option will be when the front month option expires by looking at what the time value is for options with the same time until expiration when the spread is set up. But because supply and demand change continually, the estimated time value and the actual time value may differ significantly.

As the price of the underlying moves away from the strike of a long calendar spread, losses will be incurred, but the reasons for the losses will differ, depending on whether the underlying price declines or increases. When the underlying price declines, the time value of both options tend to 0, the further the price of the underlying moves out-of-the-money. When the price increases, then time value also declines to 0, because options with high intrinsic value have little time value, so the short and long option will cancel each other out, leaving only the debit as the loss for establishing the spread.

For the short calendar spread, the opposite would occur, since the long position's gain or loss will be equal to the short position's loss or gain, respectively. The short position will be long the front month and short the back month. When the underlying price is low or high, then the time value of both options will be 0; if the price is low, then both options have little or no value; when the price is high, then the short and long options cancel each other, leaving only the credit received for establishing the short calendar spread. If the price of the underlying equals the strike price of the near option at expiration, then the short position's long option expires worthless, leaving only the short option, so the amount of money that must be paid to offset the short option must be subtracted from the credit received. Just as the maximum profit cannot be determined for the long position, so the maximum loss cannot be determined for the short position and for the same reason, since the time value of the far option at the expiration of the near option cannot be known when the spread is set up.