My Quest to Build a Million Dollar a Year Income Stream with Options Trading

Calendar Spreads- the Value of Time

Calendar spreads options, also known as a time spreads or horizontal spreads, are options trading strategies that involve buying and selling options of the same underlying asset, with the same strike price, but with different expiration dates. 

Calendar spreads profit from the relative difference in time decay rates between the two options. The goal is for the short leg to lose value faster than the long leg, leading to a net profit for the overall position.

This strategy can be implemented using either call options or put options.

How a calendar spread option works

To create a calendar spread, you choose an options contract with a particular strike price and sell it, while simultaneously buying an options contract with the same strike price but at a later expiration date. The key to a calendar spread is the difference in expiration dates between the two options. 

The option with the longer expiration date is known as the “long leg”, and the option with the shorter expiration date is known as the “short leg“. When setting up the calendar spread, the long leg typically costs more than the short leg due to the extra time value. 

The spread’s total cost represents the maximum potential loss, while the potential profit is the difference in value between the two legs.

Calendar spreads are typically used in neutral market conditions, where the underlying asset is expected to remain relatively stable in the short term. It’s essential for the underlying asset’s price not to experience significant movements during the life of the spread.

Since the goal of a Calendar spread is to profit from time and volatility, the strike price should be as near as possible to the current stock price. 

Calendar Spreads Example

Let’s look at an example Calendar Spread trade from beginning to end. For this position, I’m going to use $JPM as the underlying stock, and it has a current price of $154.95. I think this stock is trading at the top of its range, and is not likely to climb much higher. So I choose to use 155 as my strike price. I select my short position to expire in two weeks (8/04), and my long position expiring in five weeks (8/25).

Here’s what it looks like at open:

Sell 8/4 160 Call $2.10: $210

Buy 8/25 160 Call $3.5: -$350

Total Debit at open: $120

As long as the stock price remains below $160 at the time of the short option expiration, the short option will expire worthless. I’ll now be left with the long option.

Theta, or the effect of time decay on an option price, increases as the expiration date approaches. I opened this position with five weeks until expiration, and there’s still three weeks to go. As long as the stock price hasn’t dropped, it’s reasonable to assume it might still have around 2/3 of it’s orignal value ($3.50) left, or about $2.10. I can now sell to close this position, collecting $210.

Let’s look at the numbers now:

Sell 8/4 160 Call 2.10: $210 Expires worthless: 0

Buy 8/25 160 Call 3.50: -$350 Sell to Close 2.10: $210

Total Debit at open: $120 Total Credit at close: $210 Net Profit: $90

If the stock price remains right around the $155 mark, this position will make a total profit of $90.

What if the stock price rises before the short position expires? Both options will increase in intrinsic value, but the short position will still lose all of its extrinsic value. It’s value at expiration is simply the difference between the $155 strike price and the actual stock price. If the stock price is $156, the option will be worth $1×100. But the long option will also have increased in intrinsic value, offsetting that.

This strategy can handle a little upward or downward movement.

What if the stock price falls significantly before expiration? The short position will expire worthless, but the long position will also decrease significantly in value. The farther the stock price falls, the less of the original value you will retain. Theoretically, this loss could increase to a maximum of $120, or the total amount of the initial debit.

If there aren’t any major events before the first option expires, the liklihood of a significant decline is pretty low. What’s more likely is that the stock will move up or down a little, giving you somewhere between 0 and your max profit potential.

This is why it’s important to choose a stable stock. Stock’s with a high volatility don’t have as high liklihood of profitability with this strategy.

When to use a Calendar Spread option

Calendar spreads are used when you expect minimal movement in the underlying asset’s price, but anticipate that time decay will affect the shorter-term option more significantly. If you believe that the implied volatility levels of the stock will decrease over time, a calendar spread can take advantage of this expectation.

Calendar spreads can also be employed as a hedging strategy for an existing options position, providing limited risk while allowing for potential additional gains if the underlying asset remains stable.

When not to use a Calendar Spread

A calendar spread is most profitable when the underlying asset does not make any significant moves in either direction until after the short option expires.  Be careful of things like earnings releases, Fed interest rate decisions, or other external events that could cause significant price movement prior to expiration of the short position.

Similar to vertical spreads, calendar spreads offer limited risk compared to some other options strategies.  But they also come with limited profit potential. 

As with any options strategy, make sure you have a solid understanding of the risks involved before implementing a calendar spread.

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