In this chapter, we will learn an option trading strategy called ‘Calendar Spread.’
As the name suggests, it spreads over the calendar month, hence is known as Calendar spread. The logic behind calendar spread is that near month options price fluctuate more than far month.
Calendar spread can be of many types. If it is made using the call option it is called Calendar Call Spread, similarly for put it is known Calendar Put Spread.
If the Calendar Spread is made of a different month’s expiry but same strike price, it is called Horizontal Spread.
If it is made using same month expiry options but different strike price, it is called Vertical Spread. Lastly, when both the strike prices and expiry months are different, it is called Diagonal Spread.
Here, the aim is to lock in profits from changes in volatility over a period of time. One can exploit fluctuation in pricing from short-term events.
Typically, long calendar spread involves buying a far-term option and selling a near-term option that is of the same type and exercise price. A calendar spread is most profitable when the underlying asset does not move significantly in either direction until after the near-month option expires. The two identical contracts create a difference in price because of time value -specifically the amount of time that differs between the two contracts.
The goal of a calendar spread strategy is to take advantage of differences in volatility and time decay, while also trying to minimize the impact of movements in the underlying security. Depending on where the stock is relative to the strike price when implemented the forecast can either be neutral, bullish or bearish.
The long trade takes advantage of how near- and long-dated options act with change in time and volatility. An increase in IV would have a positive impact on this strategy because longer-term options are more sensitive to changes in volatility (higher vega). The caveat is that both the options may trade at different IV, but it rarely happens that the movement of volatility and the effect on the price of the spread is different from expectation.
Since this spread involves premium outflow, the maximum loss is the amount paid for the execution of the strategy. The option sold is closer to expiration and therefore has a lower price than the option bought, resulting in a premium outflow.
Ideally, we will want the market to be steady or decline slightly during the near term expiry and thereafter move higher strongly during the long term expiry. We also expect a sharp increase in IV during the long term expiry.
At the expiration of the near-term option, the maximum gain would occur when the underlying asset is at or slightly below the strike price of the expiring option. If the asset were higher, the expiring option would have intrinsic value. Once the near-term option expires worthless, the trader is left with a simple long call position, which does not cap profits on the higher side.
Basically, a trader with a bullish longer-term view can reduce the cost of purchasing a longer-term call option and selling the shorter term call option.
Let’s consider an example:
With Nifty trading at 17200 in January:
- Sell the January 17300 CE @ 200/-
- Buy the February 17300 CE @ 420/-
Net cost comes to (420-200)= 220/-
Since this is a debit spread, the maximum loss is the amount paid for the strategy. The option sold is closer to expiration and therefore has a lower price than the option bought, yielding a net debit or cost. In this scenario, the trader is hoping to capture an increase of value associated with a rising price (up to but not beyond 17300) by January expiration.
The ideal market move for profit would be for the price to become more volatile in the near term, but to generally rise, closing just below 17300 as of the January expiration. This allows the January option contract to expire worthless, and still allow the trader to profit from upward moves up until the February expiration.
If the trader was to simply buy the February expiration, the cost would have been ₹420, but by employing this spread, the cost required to make and hold this trade was only ₹220, making the trade one of greater margin and less risk.
Depending on which strike price and contract type are chosen, the strategy can be used to profit from a neutral, bullish or bearish market trend.