Calendar spread is a strategy which traders can use to profit from the difference in the time decay between two options in the short term and profit from market volatility in the long term.
Sounds too good to be true? Well, calendar spreads are real and a lot of traders are in fact using calendar spreads to earn monthly profits from the market.
Calendar spread is also called horizontal spread or time spread. As such, it involves the simultaneous buying and selling of options having different expiration dates. In most cases, a calendar spread is set up by selling an option with a shorter expiration date and buying one with a longer expiration date.
The cardinal principle behind the use of calendar spreads is the expectation that the time decay for the option with the shorter expiration date will be faster compared to the time decay for the option with the longer expiration date. In other words, this means that the value of the former will diminish more compared to the latter after a certain period of time, allowing the trader to take advantage of such difference in values.
Calendar spreads usually fall under the following types:
1. Horizontal Calendar Spreads – these are calendar spreads with the same strike prices.
2. Diagonal Calendar Spreads – these are calendar spreads with different strike prices.
Actually, knowing when to use calendar spreads is a matter of judgment. It will depend on the condition of the market. There is really no fixed rule when to use a calendar spreads since the market will always be unpredictable even with the use of hedging strategies.
However, the guideline that most traders follow is that they use calendar spreads when they can earn a decent profit brought by the time decay enough or more to offset their initial debit.
For example, let’s assume that on February, you hold a call option that allows you to buy 100 shares of Apple Company with a strike of $500 on or before May 30, the expiration date. You can set up a calendar spread by selling that call option for $200 and simultaneously buying another call option for the same underlying stock with the same strike price but with a June 30 expiration date, for $300. Setting up this calendar spread has cost you an initial debit of $100. This is normal because options with longer expiration dates have a higher time value, hence, causing the value of the option to be priced higher. This transaction is summarized in the table below:
After two months, there were dramatic changes in the price of the options. Due to time decay, the values of the options changed to the following as of April 30.
According to the table, there is a greater decrease in the value of the May 30 option than the June 30 option. This is due to the fact that the time decay is faster for options that are expiring sooner than options that are expiring on a later date. At this point, it would be wise to close your calendar spread position by selling the June 30 option you bought and buying back the May 30 option. This would give you a profit of $100 (250 – 50 – initial debit of $100).
Moreover, you already earned a profit of $100 even before the expiration of any of the two options. You recovered your initial debit and earned an additional amount.
But there’s something more. After closing your calendar spread position, remember that you are still currently in possession of the May 30 call option. This means that while you already have a profit of $100 from the calendar spread, you can still earn more if there are abrupt changes in the price of the stocks after April 30 and before May 30.
Therefore, with the use of calendar spreads, not only are you able to profit from the differences in time decay in the short term, you can also profit from market volatility in the long term!
So what are you waiting for? Mark your calendar. Contact your broker and start using calendar spreads!
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