Understanding Calendar Spreads

Till now, we’ve only been looking at strategies where options with the same expiration date are executed. But what if we could execute options with different expiration dates? Is that even possible? If yes, what would be the outcome? The answer to all of these questions lie in an options strategy that traders refer to as a ‘calendar spread’. And this strategy is precisely what we’re going to be looking at in this chapter of Smart Money. So, let’s begin.

What is a calendar spread?

Also known as time spread or horizontal spread, a calendar spread is an options trading strategy where you’re required to execute the same type of option for a given asset at the same strike price, but with different expiration dates. The calendar spread is a versatile options trading strategy that can be used in bullish, bearish, and neutral market situations. That said, traders prefer to use it in neutral market and range bound market situations only.

How to set up a calendar spread?

Setting up a calendar spread trading strategy requires selling an options contract of an asset with a shorter expiration date and purchasing the same options contract with the same strike price, but with a longer expiration date.

Confused? Don’t worry. Here’s something that can give you some much-needed clarity. To set up a calendar spread trading strategy, the steps that you need to follow are given below.

• Sell an out of the money (OTM) call option with a near-term expiry date. 
• Purchase an out of the money (OTM) call option with the same strike price and a longer-term expiry date.

This particular calendar spread trading strategy deals with call options and is known as bull calendar spread and is just one version. In fact, there are three versions of a calendar spread - bear calendar spread and neutral calendar spread.

Here’s what you need to do to set up a bear calendar spread.

• Sell an out of the money (OTM) put option with a near-term expiry date. 
• Purchase an out of the money (OTM) put option with the same strike price and a longer-term expiry date.

As you can see, the only difference between the bull calendar spread and bear calendar spread is the type of option that you purchase and sell.

And finally, here’s what you would have to do to set up a neutral calendar spread.

• Sell an at the money (ATM) call option with a near-term expiry date.
• Purchase an at the money (ATM) call option with the same strike price and a longer-term expiry date.

This version of the calendar spread strategy is slightly different. We get to use ATM options in this one, as opposed to OTM options in the other two.

How does the calendar spread work?

Now that you know how to set the options strategy up, let’s move on to the example part and see how it works. Before we get to the three scenarios, here are the assumptions that we’re going to make.

• You’re interested in the stock of Federal Bank. 
• You wish to set up a bull calendar spread. 
• The stock is currently trading at Rs. 80. 
• The lot size of the options contract of this stock is set at 10,000.
• The near-term expiry date for the options contract of this stock would be May, 2021. 
• The longer-term expiry date for the options contract of this stock would be June, 2021.

To execute a bull calendar spread, here’s what you need to do in this example.

• Sell an out of the money (OTM) call option with a near-term expiry date. In this case, it would have to be FEDERALBNK MAY 90 CE. Let’s assume that the premium for this contract is Rs. 1.50 per share. So, by selling 1 lot of OTM call options, you receive Rs. 15,000 (Rs. 1.50 x 10,000).
• Purchase an out of the money (OTM) call option with the same strike price and a longer-term expiry date. In this case, it would be FEDERALBNK JUN 90 CE. Let’s assume that the premium for this contract is Rs. 3 per share. So, to purchase 1 lot of OTM call options, you would have to pay Rs. 30,000 (Rs. 30 x 10,000).

By executing these two options, you end up with a net debit of Rs. 15,000 (Rs. 30,000 - Rs. 15,000), which you would have to pay. Now, let’s take up three scenarios and see how this options trading strategy performs in each of them.

Scenario 1: The share price goes up to Rs. 85 on near-term expiry and rises even further up to Rs. 95 on longer-term expiry

In such a situation, here’s what’s likely to happen.

• The FEDERALBNK MAY 90 CE that you sold would expire worthless. This would allow you to retain the premium of Rs. 15,000 (Rs. 1.50 x 10,000) that you collected.
• The FEDERALBNK JUN 90 CE that you purchased would make a profit of Rs. 5 per share. The profit that would receive on this transaction would then be Rs. 50,000 (Rs. 5 x 10,000).

The total net profit from these two positions would ultimately come up to Rs. 35,000 [Rs. 50,000 - Rs. 15,000].

Scenario 2: The share price falls down to Rs. 75 on near-term expiry and falls even further down to Rs. 70 on longer-term expiry

If the share price falls and continues to keep falling, here’s what’s likely to happen.

• The FEDERALBNK MAY 90 CE that you sold would incur a loss of Rs. 15 per share. The loss that you would have to bear in this scenario would then be Rs. 1,50,000 (Rs. 15 x 10,000).
• The FEDERALBNK JUN 90 CE that you purchased would expire worthless since the strike price is higher than the spot price.

The total net loss from these two positions would ultimately come up to Rs. 1,65,000 [Rs. 1,50,000 + Rs. 15,000].

Scenario 3: The share price stays at 80 on near-term expiry and on longer-term expiry

Let’s assume that the share price stays the same throughout both the expiries. Here’s a glimpse of what would happen.

• The FEDERALBNK MAY 90 CE that you sold would expire worthless since the strike price is higher than the spot price. This would allow you to retain the Rs. 15,000 that you received as premium.
• The FEDERALBNK JUN 90 CE that you purchased would also expire worthless since the strike price is higher than the spot price.

The total net loss from these two positions would ultimately only come up to Rs. 15,000, which is the net debit amount.

Wrapping up

As you can see from the above, the bull calendar spread works well only when the share price moves up. If it goes down against your view, the losses can be severe. Now that you know how this options strategy works, try to find out what the results are likely to be for the remaining two calendar spread trading strategies - bear calendar spread and neutral calendar spread. In addition to the three scenarios listed above, you could come up with some of your own as well to test the strategy.

A quick recap

• Also known as time spread or horizontal spread, a calendar spread is an options trading strategy where you’re required to execute the same type of option for a given asset at the same strike price, but with different expiration dates.
• This is a versatile trading strategy that can be used in bullish, bearish, and neutral market situations. Generally, however, traders prefer to use it in neutral market and range bound market situations only. 
• To set up a calendar spread, you need to sell an options contract of an asset with a shorter expiration date and purchase the same options contract with the same strike price, but with a longer expiration date. 
• There are three versions of the calendar spread, namely the bull calendar spread, the bear calendar spread and the neutral calendar spread.