The Calendar Spread

Last time we spoke I introduced you to volatility. Now after a break for the holidays, I'm going to teach you how to take advantage of it! Today, we're going to talk about a new option strategy that takes advantage of both rising volatility and time decay, called the calendar spread.

Just a Matter of Time…

So what is the calendar spread? And why is it a useful option strategy to know about? The calendar spread is an interesting strategy. In many ways it's a mix of writing a covered call and buying a call with a different expiration date at the same time. Let me break it down for you.

A calendar spread can be constructed with both calls and puts depending on your general opinion of the market or stock. However, for the sake of clarity we will only consider a spread involving calls. Because we are considering calls, we have an overall bullish opinion of the stock we are constructing the spread with. However, with a calendar spread we are neutral in the short-term. So what exactly does a calendar spread entail?

To create a calendar spread you buy a long-term option and sell a short-term option of the same strike price. The idea is that you will take advantage of the heightened time decay of the short-term option and make substantial profits when it expires (hopefully worthless.) After that time you can either close the position, or keep your long-term option (which you've now obtained at a nice discount), and let your view of the market take its course.

Another nifty feature of the calendar spread is how an increase in implied volatility affects the position. As implied volatility increases, the price of both calls and puts also increase. This increase in price has a larger effect on long-term options than short-term options, thus when this happens a calendar spreader benefits, and sometimes quite substantially.

Personally, I find the calendar spread an incredibly attractive strategy. Not only does it limit your risk exposure (your maximum loss is the amount paid to open the position), but it also allows for a very hefty profit. At times the shorter term option will expire and leave your longer term option with 100%+ in gains! What surer profit is to be had in the option's market than that gained from time decay?

Until next time,

Spencer Sundahl