Also referred to as horizontal or time spread, a calendar spread is a well-known options trading strategy employed by traders and investors to capitalise on variations in potential future price movements of an underlying security. This tactic involves the purchase and sale of options at the same time. The concerned options have similar strike prices but different dates of expiry. Both call and put options can be used to execute this strategy. Typically, traders will invest in a long-term option while simultaneously selling a short-term option with similar strike prices.
The main purpose of a calendar spread strategy is to profit from “theta”, or the time decay element of option prices. Compared to longer expirations, options with shorter expiry dates undergo time decay rapidly. Traders derive gains from decay rates when the underlying security’s price fluctuates in a way that favours the spread’s composition. Calendar spreads are usually viewed as neutral and are used by traders when they anticipate limited price movement in the underlying security.
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Who should choose a calendar spread options strategy?
A calendar spread strategy is generally best used when you have precise market expectations along with adequate risk tolerance.
- Income traders: Income traders find calendar spreads to be a lucrative options trading strategy as they can make money via the time decay of options. It can offer regular and comparatively low-risk income in stable or reasonably trending markets.
- Volatility expectation traders: If a trader forecasts that volatility will soar in the short-term but decline in the distant future, then such a spread can catch the anticipated volatility rise in short-term options. At the same time, it maintains exposure to the underlying security for a longer period.
- Neutral market traders: Calendar spreads can help traders who predict an underlying security’s relative stability or restricted price movements. This can enable them to earn from the time decay while diminishing their exposure to considerable directional risk.
- Risk-averse investors: With defined risks, the potential losses in calendar spreads are capped to the initial investment. This renders them viable for individuals who want to control and confine their exposure to risk.
- Options income investors: Investors who hold a portfolio of stocks or other types of assets can use calendar spreads to improve their income via options.
- Options traders with stipulated capital: Calendar spreads are comparatively less capital-intensive than other options strategies. This makes them appealing to traders who have fixed capital to trade.
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Advantages of calendar spread strategy
- Income: Calendar spreads can earn income via theta or time decay of options, making them an ideal solution for income-focused traders.
- Lower risk: The risk embraced in this technique is outlined and restricted to the initial investment, which makes it perfect for cautious traders.
- Lower exposure to volatility: These strategies can help reduce the effect of changes in implied volatility as they comprise both short and long options, which offset each other to a certain degree.
- Adaptable: Calendar spreads can be used in different circumstances, including stable, relatively bearish, or relatively bullish markets.
- Limited capital investment: Calendar spreads typically need smaller capital as compared to other options trading strategies, which makes them advantageous for traders with limited funds.
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Disadvantages of calendar spread options strategy
- Modest profit potential: The highest gains in a calendar spread that you can achieve is capped, and it is often smaller than the expected loss, particularly in volatile markets.
- Time-sensitive: Calendar spreads rely on options losing their value because of time decay. If the underlying security fails to shift favourably, it can erase predicted profits.
- Directional risk: While these strategies are considered to be neutral, they still hold some amount of directional risk. If the underlying asset makes substantial price movements, you could incur losses.
- Intricate: Like most trading strategies, calendar spread strategies need an astute knowledge of options as well prevailing market trends. So, they might not be the best route for an entry-level trader.
- Transaction costs: Since numerous options contracts are required in a calendar spread, you might have to manage increased transaction-related expenses, including high brokerage commissions.
- Margin requirements: Certain brokers may impose margin requirements for calendar spreads that could lock some part of the trading capital, constraining your scope to use those funds for other investing opportunities.
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Closing thoughts
All things considered, calendar spreads are a productive options trading strategy, especially for traders seeking consistent income from a low-risk environment. While they offer controlled risk exposure and specific profit and loss parameters, they also have drawbacks such as limited gains, theta sensitivity, and possible directional risk. Also, calendar spreads might be neutral in nature, but they are equally complicated like most trading techniques and need you to be an expert in the options market and fiscal trends. So before you jump on the calendar spreads bandwagon, ensure that you have done your homework to make the most out of your capital investment.
