• Nivesh Hiran

Calendar Spread

A calendar spread sometimes called a time spread or a horizontal spread, is an option strategy that involves buying one option and selling another option with the same strike price but with a different expiration date. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time.

At-expiration diagrams do a calendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value. To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks.

There are two things to remember when it comes to calendar spreads: 1. If the stock price moves too far from our strikes, the trade will become a loser. 2. An implied volatility increase will help our trade make money.

Keeping this information in mind is most helpful when setting up the trade. We pick strikes that are near the stock price, if not right on the stock price we may skew it slightly bullish or slightly bearish if we have a small directional assumption, but it will be very close to the stock price regardless - that gives us the most exposure to profit or loss with changes in implied volatility.

For example, a trader, XYZ, watches Nifty Index on a regular basis & enters the trade on 24th July 2020. XYZ believes that Nifty will trade in a range of around Rs. 11200 (where it is trading now) over the next week. XYZ buys the 30th July-6th August 11200 call calendar for 35.9. Assuming 30th July has 6 days until expiration and 6th August has 13 days, XYZ will execute the following trade:

XYZ’s best-case scenario occurs when the 30th July 11200 Call expires At-the Money and the 6th August calls retain much of their value.

If XYZ created an at-expiration P&(L) diagram for his position, he’d have trouble because of the staggered expiration months. A general representation would look something like this

Pay-Off Chart

The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at the expiration of the 30th July call.

Scenario 1:

The maximum loss if Nifty falls low enough is 35.9— the debit paid for the spread. If Nifty is below Rs. 11200 at 30th July expiration, the 30th July 11200 call expires worthless, and the 6th August 11200 call may or may not have residual value. If Nifty declines enough, the 6th August call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 35.9 debit would be a loss.

Scenario 2:

If Nifty is above Rs. 11200 at 30th July 2020 expiration, the 30th July 11200 call will be trading at parity. It will be a negative-100-delta option, imitating short stock. If Nifty is trading high enough, the 6th August 2020 11200 call will become a positive-100-delta option trading at parity plus the interest calculated on the strike. The 6th August 2020 deep-in-the-money option would imitate long stock. The maximum loss if Nifty is trading over Rs.11200 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 35.9, the premium paid, if there is no time value or carry considerations.

Scenario 3:

The maximum profit is gained if Nifty is at Rs.11200 at expiration. At this price, the 6th August 11200 call is worth the most it can be worth without having the 30th July 11200 call assigned and creating negative deltas to the upside. But how much precisely is the maximum profit?

XYZ would have to know what the 6th August 11200 call would be worth with Nifty stock trading at Rs.11200 at 6th August 2020 expiration before he can know the maximum profit potential. Although XYZ can’t know for sure at what price the calls will be trading, he can use a pricing model to estimate the call’s value.

The Strength of the Calendar

Spreads in the calendar-spread family allow traders to take their trading to a higher level of sophistication. More basic strategies, like vertical spreads and wing spreads, provide a practical means for taking positions in direction, realized volatility, and to some extent implied volatility. But because calendar-family spreads involve two expiration months, traders can take positions in the same market variables as with these more basic strategies and also in the volatility spread between different expiration months. Calendar- family spreads are veritable volatility spreads. This is a powerful tool for option traders to have at their disposal.

Source: Trading Options Greek By Dan Passarelli.


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