Calendar Spreads in Futures and Options Trading Explained

What Is a Calendar Spread?

A calendar spread is an options or futures strategy established by simultaneously entering a long and short position on the same underlying asset but with different delivery dates.

In a typical calendar spread, one would buy a longer-term contract and go short a nearer-term option with the same strike price. If two different strike prices are used for each month, it is known as a diagonal spread.

Calendar spreads are sometimes referred to as inter-delivery, intra-market, time spread, or horizontal spreads.

Understanding Calendar Spreads

The typical calendar spread trade involves the sale of an option (either a call or put) with a near-term expiration date and the simultaneous purchase of an option (call or put) with a longer-term expiration. Both options are of the same type and typically use the same strike price.

• Sell near-term put/call
• Buy longer-term put/call
• Preferable but not required that implied volatility is low

A reverse calendar spread takes the opposite position and involves buying a short-term option and selling a longer-term option on the same underlying security.

Special Considerations

The purpose of the trade is to profit from the passage of time and/or an increase in implied volatility in a directionally neutral strategy.

Since the goal is to profit from time and volatility, the strike price should be as near as possible to the underlying asset's price. The trade takes advantage of how near- and long-dated options act when time and volatility change. An increase in implied volatility, all other things held the same, 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 the two options can and probably will trade at different implied volatilities.

The passage of time, all other things held the same, would have a positive impact on this strategy at the beginning of the trade until the short-term option expires. After that, the strategy is only a long call whose value erodes as time elapses. In general, an option's rate of time decay (theta) increases as its expiration draws nearer.

Maximum Loss on a Calendar Spread

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.

The ideal market move for profit would be a steady to slightly declining underlying asset price during the life of the near-term option followed by a strong move higher during the life of the far-term option, or a sharp move upward in implied volatility.

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 has no upper limit on its potential profit.

Basically, a trader with a bullish longer-term outlook can reduce the cost of purchasing a longer-term call option.

Example of a Calendar Spread

Assume that Exxon Mobile (XOM) stock is trading at $89.05 in mid-January, you can enter into the following calendar spread:

• Sell the February 89 call for $0.97 ($97 for one contract)
• Buy the March 89 call for $2.22 ($222 for one contract)

The net cost (debit) of the spread is thus (2.22 - 0.97) $1.25 (or $125 for one spread).

This calendar spread will pay off the most if XOM shares remain relatively flat until the February options expire, allowing the trader to collect the premium for the option that was sold. Then, if the stock moves upward between then and March expiry, the second leg will profit. 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 95 as of the February expiration. This allows the February option contract to expire worthless and still allow the trader to profit from upward moves up until the March expiration.

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 $95) between purchase and February expiration.

Note that if the trader were to simply buy the March expiration, the cost would have been $222 dollars, but by employing this spread, the cost required to make and hold this trade was only $125, making the trade one of greater margin and less risk. Depending on which strike price and contract type are chosen, the calendar spread strategy can be used to profit from a neutral, bullish, or bearish market trend.