Calendar spreading is a simple strategy that appeals to many traders, but it has some limitations, which we will explore. First, the definition: a calendar spread is constructed by buying an option at a certain strike and simultaneously selling the same type of option at the same strike, but the option that is sold expires earlier than the option that is bought.

Examples: XYZ is trading at 100. Any of the following would be calendar spreads:

Buy XYZ Jan 100 call & sell XYZ Nov 100 call
Buy XYZ Dec 90 put & sell XYZ Nov 90 put
Buy XYZ Jan 110 call & sell XYZ Dec 110 call

In each case, the type of option is the same: that is, if one buys a call, he/she also sells a call; if the person buys a put, he/she also sells a put. Moreover, in each case, the option that is bought has more time remaining than the option that is sold.

In this type of position, one has essentially created a spread on time because the strikes and types of options are the same. Hence, the name "time spread" or, more commonly, "calendar spread" is applied to this strategy. The idea behind the strategy is to be able to capture the faster rate of decay of the short-term option without having a lot of exposure to the movement of the underlying security.

The graph in Figure 1 depicts the profit curve for a typical calendar spread when the near-term option is expiring. A strategist will always treat a spread as a single entity and will remove it when one side expires. Note that there is a definite profit area that is more or less centered around the striking price of the options in the spread. Moreover, if the underlying stock or index moves too far away from the strike, a loss will result. However, that loss is limited to the initial cost of the spread because a longer-term option cannot sell for less than a shorter-term one with the same striking price. Thus, the chance to capture time decay with a limited risk exposure makes this an attractive strategy for many traders.

Drawbacks to Calendar Spreading

The strategy has its drawbacks as well. First, there is the fact that multiple commissions on a spread will eat into the profit potential. Second, there is usually a very likely chance that the stock will move outside of the profit area. Some traders attempt to counter this tendency by establishing calendar spreads when the near-term options have only 2 or 3 weeks of life remaining. This means, unfortunately, that a larger debit is being paid and, hence, the risk is greater (in dollars) if the stock moves away from the strike. Finally, if the calendar spread is established after implied volatilities have increased, there is the problem of a subsequent decrease in implied volatility.

Determining If the Spread Is Attractive

We are not proponents of merely establishing a strategy because it is "there." We want to have an edge. For calendar spreads, this would mean that we want to sell an option that is more "expensive" than the one we are buying; that is, we want the implied volatility of the option we are selling to be higher than that of the option we are buying. This is sometimes called a horizontal skew and is what is referred to in the audio clip on the eSignal Central website that discusses methods of finding this strategy.

The graph in Figure 2 shows the hypothetical advantage of having sold the more expensive options. The higher curve -- the one with the bigger profit potential -- depicts a calendar spread in which one sells a call that has a higher implied volatility (i.e., is more expensive) than the one that he/she purchases. The lower curve depicts the same spread if both options initially have the same implied volatilities. Notice that the "expensive sale" graph has a profit area of approximately 93 to 109 for XYZ at expiration, while the other has a considerably smaller profit area of 95 to 107.

When can one reasonably expect to find a situation where the near-term options are more expensive than the longer-term ones? Typically, during periods of increased volatility or at least increased implied volatility. When a stock or index makes a large move - particularly a large downward move - near-term options become expensive as traders rush in to either buy them as a hedge or as a speculation. There is generally less of that speculation in the longer-term options and, therefore, the calendar spread seems to be an attractive strategy at that time. Note that the longer-term options' implied volatility will have generally increased as well, but not by as much as the short-term options' volatility has.

Lawrence G. McMillan is author of several books on options, including Options As A Strategist Investment and McMillan On Options. He is also President of McMillan Analysis Corp., an advisory firm specializing in option analysis, recommendation and money management. McMillan Analysis Corp. publishes three newsletters on options - trials to all of which can be obtained by registering on the website at www.optionstrategist.com.

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