If you are new to options trading and wish to try something that balances profit and loss, then the calendar spread strategy is something you need. But, how does this work? This strategy works by buying and selling two options with the same strike price but different expiration dates. So, it is great for taking advantage of time decay, which is an important factor in options trading.
Let’s learn more about this calendar spread options strategy and understand how it works.
What is a Calendar Spread?
When you combine two options - one you buy and the other you sell - this options trading technique is called a calendar spread. The trick is that both options have the same strike price, but the one you buy has a longer expiration date than the one you sell. The major components are:
- Strike Price: The price you agree to buy or sell the underlying asset.
- Expiration Date: The date on which the option expires.
Types of Calendar Spreads
Calendar spreads can be divided into two categories according to whether you are using put or call options:
1. Call Calendar Spread
A call calendar spread is used when you expect the stock price to stay stable or rise slightly.
2. Put Calendar Spread
Traders use a put calendar spread when they expect the stock price to stay the same or fall a little.
How Does a Calendar Spread Work?
Now, comes the key question - how does a calendar spread work? Let’s find out!
In the calendar spread strategy, the time decay of options plays a key role. As an option gets closer to its expiration date, it loses value, and this is time decay in action. The calendar spread option strategy makes money when the short-term option you sell loses value faster than the long-term option you buy.
Here are the steps to execute a calendar spread:
Step 1: Pick a Stock: Choose a stock you expect to remain stable in price.
Step 2: Select the Strike Price: This is usually close to the stock’s current price.
Step 3: Buy a Long-Term Option: Purchase an option with an expiration date that’s a few months away.
Step 4: Sell a Short-Term Option: Sell an option with the same strike price, but one that expires sooner.
Now,
- If the stock price stays close to the strike price, the short-term option (the one you sold) would lose value faster due to time decay.
- The long-term option (the one you bought) would lose value more slowly. This would allow you to profit from the difference in how quickly each option loses value.
Profit and Loss in Calendar Spreads
How You Can Make Money
The calendar spread strategy is designed to make money when the short-term option expires to become worthless or loses value faster than the long-term option. If the stock price stays near the strike price when the short-term option expires, you can sell another short-term option and continue earning from time decay.
Risks of Loss
Like any trading strategy, the calendar spread has its risks. The biggest risk is if the stock price moves in either direction (too high or too low), thereby causing both options to lose value. This can lead to a loss, though the amount of risk depends on the initial cost of setting up the trade.
Example of profit or loss in different scenarios:
| Situation | Stock Price Stays Stable | Stock Price Moves Too Much |
| Time Decay (short-term option) | Option loses value fast | Both options lose value |
| Time decay (long-term option) | Option retains value | Option loses value |
| Profit or Loss | Profit | Loss |
When to Use a Calendar Spread
The calendar spread option strategy works best in specific situations. Ideally, you use it when you expect the stock price to remain relatively stable until the short-term option expires. Here are some situations when you can use it:
- When the stock market is stable or has low volatility
- When the price is expected to be near the strike price
What is a double calendar spread?
A double calendar spread is a trading strategy that involves buying options with longer expiration dates and selling options with shorter expiration dates, for both call and put options. This strategy is often used in market conditions with low volatility.
In this strategy, long-term options expire later than the short-term options. This way you can hold on to the options for a longer time, which allows you to take advantage of different time decay rates.
Advantages of the Calendar Spread Strategy
- Your maximum risk is the initial cost of the trade. This is why the calendar spread is considered to be a lower-risk strategy compared to others.
- The strategy takes advantage of the fact that short-term options lose value faster than long-term options.
- You can continue selling short-term options after one expires to earn multiple times from the same trade.
Disadvantages of the Calendar Spread Strategy
- While the risk is lower, the profits in a calendar spread are usually smaller compared to riskier strategies.
- If the stock price moves too much in either direction, then the calendar spread strategy can result in a loss.
- To maximise profit, you need to correctly predict both the stock price movement and the time frame of that movement.
Managing Your Calendar Spread
You need to pay close attention to the market conditions and adjust the trade when necessary to manage a calendar spread strategy. Here are some tips for you:
- If stock volatility increases unexpectedly, it can impact your profits, so it is important to monitor market conditions.
- Once the short-term option expires, you can ‘roll’ the trade by selling another short-term option with the same strike price.
- If the stock price moves too much or if you have reached your profit target, it may be best to close the trade early.
Conclusion
So, the calendar spread option strategy is a great way to trade options by making use of the time decay. Now, if you are ready to try this strategy, Tradejini is a great online trading platform to help you. With the Tradejini CubePlus app, you can easily place calendar spreads and other trades, all with low fees and simple tools.
So, download the CubePlus app today!
Also Read: Understanding Stock Market Investors: Retail vs. Institutional
