Explanation of Calendar Spreads
The simple definition of a calendar spread is that it is basically an options spread that involves options contracts with different expiration dates. There are several types, including horizontal spreads and diagonal spreads. They are commonly referred to as time spreads too.
The term calendar spread is used because you are effectively spreading options across the calendar based on their differing expiration dates. The term time spread is used because they are largely based on essentially profiting from time decay. On this page we offer more information on them and how they are created.
You should be aware that this page is basically an overview of calendar options and how they work rather than a detailed tutorial of how to use them in your trading. We have written pages on a number of the main types of options that all serve the same purpose; to define the various types and clearly explain how they are created and used in easy to understand terms. For a more in depth look at all the different types and information on precisely how they can be used, we would strongly recommend reading our section on Options Trading Strategies.
The following topics are covered on this page:
- Creating Calendar Spreads
- Types of Calendar Spreads
- Using Calendar Spreads
Creating Calendar Spreads
In basic terms, these are created by writing options contracts and then buying contracts of the same type and underlying security with a later expiration date. If the contracts you write, using a sell to open order, have the same strike price as the ones you buy then you have created a horizontal calendar spread. If the contracts you write have a different strike price to the ones you buy, using a buy to open order, then you have created a diagonal calendar spread.
Types of Calendar Spreads
As you can see from the above, there are different types of calendar spreads. Where the options involved have the same strike price you have created a horizontal calendar spread and where the options involved have different strike prices you have created is a diagonal calendar spread. There are further classifications too. These are outlined as follows.
Call Calendar Spread: This is where only calls are involved, and the contracts have the same strike price.
Put Calendar Spread: This is where only puts are involved, and the contracts have the same strike price.
Call Diagonal Calendar Spread: This uses calls only, with different strike prices.
Put Diagonal Calendar Spread: This uses puts only, with different strike prices.
Calendar Straddle: This uses both calls and puts, with the same strike price.
Calendar Strangle: This uses both calls and puts, but with different strike prices.
Using Calendar Spreads
The primary use with these is to benefit from time decay. Time decay basically relates to the decrease in extrinsic value that options contracts experience over time and, generally speaking, shorter term contracts have a faster rate of time decay than longer term contracts. As such, the idea is that by having a short position on short term contracts and a long position on longer term contracts you are able to make a profit from the differing rates of time decay.
To really understand the concept behind this, you should know about options greeks (click here for more on these) and how they measure the price sensitivity of options contracts based on various factors. In particular, you should know about options theta which relates to the factor of time decay in options pricing.
The basic idea, though, is simply that calendar spreads can be used to profit from the time decay in the options contracts you write. This does present the question though, as to why a trader would use them rather than simply writing calls and profiting from time decay that way. There are two main reasons for this.
The first is lowering margin requirements. When you write calls without owning the underlying security, or write puts contracts without having a short position on the underlying security, then this is known as a naked write. Basically you don't actually have a relevant position in case the holder of the contracts you have written decides to exercise their option.
A naked write requires margin on that trade, which can tie up a significant portion of either your available capital or your available margin. By also buying options contracts of the same type and on the same underlying security, you can reduce the margin requirements, as should the holder of the contracts you have written decide to exercise you can also exercise.
The second reason for using calendar spreads is for limiting potential losses on the contracts you write. If you have written calls and the underlying security goes up in value above the strike price, then you will incur a loss. However, this loss will be offset by the fact that you also own calls on the same underlying security.
Therefore you can potentially profit from time decay without requiring large margin and also without being exposed to too much risk. The flip side to this is that the potential profits you can make are more limited than a simple naked write. However, calendar spreads are also more versatile; you are effectively holding both a long position and a short position on the same options contracts, and you can close out one of those positions and leave the other position open should you wish.