- 2001: Volume 10, No. 5 Back to Basics: Dissecting a Calendar Spread

What do calendar spreads, butterfly spreads, condors, and iron butterflies have in common? They're all options strategies that can be used to take advantage of sideways moving markets. Now you may have no idea what any of these strategies are, and might even be a bit intimidated by them; in which case, you may never have bothered to take the time to learn about them. Well, nobody said making money was easy, and when stocks don't move up or down, we either need to stay out of the kitchen, or learn to use the new food processor, regardless of how cumbersome it may seem.

As silly as it may sound, the most difficulty traders have with spreads, whether they are vertical (different strikes, same month) or diagonal (same or different strikes, different months), lies in understanding just how they become profitable. This is due to the multiple affects that delta, volatility (vega) and time (theta decay) have on each leg of a spread as expiration approaches. This is also the reason why spreads rarely become profitable as quickly as just buying calls and puts (and adversely, why they don't lose money as quickly either). Since I can't cover all these spreads today, let's just pull apart the calendar spread.

Calendar spreads are diagonal spreads in which a shorter-term option is sold against a longer-term option of the same kind of contract (calls or puts). In other words, a calendar spread is nothing more than a unique way to finance the long-term option, without taking on margin or putting up additional capital. Inversely it can also be viewed as a method for purchasing a long-term contract at a discount. Here's how it works:

Suppose on July 9, you decided that EMC Corp. (EMC) had taken enough of a beating after collapsing from a price of $30 to where it stands at $22.32 in a single session. You feel that it will rebound eventually, but will probably do so only after a period of consolidating sideways for a month or two. The January $25 calls are asking $3.60 ($360 per contract) and the August $25 calls are bid at $1.00 ($100 per contract). This being the case, you can purchase the January call and opt to sell the August call against it to form a calendar spread, thereby lowering your net debit to .60 (or per contract). Now, as long as the stock does not exceed $25 before expiration Friday in August, the August contract will expire worthless because there is no intrinsic nor time value left in the option. However, there is still plenty of time value left in the January contract. Just how much depends on the price of the stock at August expiration, and is exactly why you should be using some sort of analysis software (such as our Platinum site) to help you see theoretically just how much that January option will be worth.

Now there's a couple of scenarios that would make this play profitable in a short period. Taking a look at the following risk graph of this very play, according to the chart, we should realize a profit at August expiration if the stock were anywhere above $21.56 and below $32.27. Our maximum profit is reached at exactly $25. The question most people have at this point is "Why?" (See Figure 1).

Figure 1: Risk Graph of a Calendar Spread

Source: Optionetics Platinum

Here's where it gets a little confusing. Remember that we bought the spread on July 9, with the stock trading at about $22.32. Both the January and August calls in this play are out-of-the-money, and therefore contain only "extrinsic" value (time value). Time value decays most quickly in the last 30 days prior to expiration. Suppose that the stock remains at $22.32 on expiration. Since both contracts are $25 strikes, it makes sense that the August contract will expire worthless if the stock sits below $25, while the January will continue to carry a premium; though it too will lose a bit of time premium, or extrinsic value. However, the August contract will lose value more quickly than the January. This is known as the spread "widening." As Figure 2 points out, if all things remain equal by then (volatility, etc.), you can actually close the play out at this point for a profit of because the January contract can theoretically be sold for about $3.10. (I derived that number by adding the $50 or $.50 per contract to our original debit of $2.60).

Figure 2: Risk Profile of EMC Calendar Spread

Source: Optionetics Platinum

So you see, the premium of the January contract has actually diminished from its purchase price of $3.60. Since it lost only 50 cents, while the August contract lost $1, it's easy to see how the spread widened and became profitable.

So how is it that we can reach maximum profitability if the stock rises and finishes at $25 on expiration? First, time decay wiped out the August contract, rendering it worthless. However, although the January contract will experience time decay, the contract itself carries a delta close to 50. Delta is how much the option rises in value for every dollar the stock rises. In this case, the contract will rise at least 50 cents per $1 rise in the stock, giving the contract a boost of about $1.40. At $25, the spread has reached maximum profitability because at that point, the short contract (August) begins to incur intrinsic value, which works against our play; as we would need to buy the contract back to close the position and avoid assignment.

This brings me to the next point about how it is we start to lose money on the spread as the stock falls above and below our breakeven points. Since we shorted the same strike as we purchase, as EMC rises, the delta of both contracts will approach 100 on anything over $25 and thus trade at parity, or dollar for dollar with the stock. By the time this happens, the contracts are so deep in-the-money, they have no more time value in them.

In other words, if EMC traded at $60, both contracts would be asking $35 apiece. Any time you have a short position in-the-money at expiration, you can be assured of assignment, which is cancelled out by exercising the long contract. So by the time true parity does occur, even though they cancel each other out, you're original debit in the play is $2.60. This is also your maximum loss.

On the contrary, were EMC to continue its slide down, we already know that the August contract will be worthless. But the January contract still has some time value on its side. Therefore, for the contract to lose all of its value, taking our original debit with it, the stock would have to fall well below $20. (See Figure 3).

Figure 3: Risk Profile of EMC Calendar Spread

Source: Optionetics PlatinumAs you can see, these spreads can be quite intricate; fully understanding them certainly requires a learning curve. But those who take the time to study these types of strategies have a better shot at achieving the goal of actually making money in virtually any type of market.

Until next time, happy trading...

Michael Bennett is a trading strategist and staff writer with Optionetics.com. He can be reached at mbennett@optionetics.com.