Calendar Call Spread

When to Use a Calendar Call Spread

As we have mentioned above, the calendar call spread is used to generate a profit when a security doesn't move much in price. Therefore, you would use it when your outlook is neutral, and you believe the price of a specific security is going to go through a period of stability.

The maximum loss is limited to the amount you spend when establishing the spread, and there's no risk of incurring additional losses if the price of the security should move dramatically in either direction. This makes it a good strategy to use if you have some concerns that this could happen.

How to Use a Calendar Call Spread

Setting up a calendar call spread is really quite simple. You need to write calls based on the relevant security, with a near term expiration date (ideally around a month or so). You also need to buy the same amount of calls based on the same security, and with the same strike, with a longer term expiration date.

The longer term options that you buy will be more expensive, due to having more time value, making this a debit spread with an upfront cost at the time of establishing it. Generally speaking, you should look to carry out the two transactions at the same time, but you can use legging techniques if you prefer.

As it uses options with the same strike, it's a horizontal spread, and it's typically established using options that are at the money. You can use slightly out of the money options, with a higher strike, to reduce the cost of the spread if you want to.

We have provided an example below of how you can create this spread, using at the money calls. Please be aware that this a hypothetical example intended for guidance purposes only, and it doesn't use real market data or incorporate commission costs.

• Company X stock is trading at $50, and you believe it will remain at that price in the short term.
• At the money calls (strike $50) with a near term expiration date are trading at $2. You write 1 contract containing 100 of these options for a credit of $200. This is Leg A.
• At the money calls with a longer term expiration date are trading at $4. You buy 1 contract containing 100 of these options, at a cost of $400. This is Leg B.
• You have created a calendar call spread for a net cost of $200.

Potential for Profit & Risk of Loss

Many options trading strategies have precise calculations that can be used to determine in advance exactly what the potential profit of using them can be, depending on how the price of the underlying security moves. However, with the calendar call spread this isn't really possible, because the profits ultimately depend on how time decay affects the price of the options involved. You can use a pricing model such as the Black Scholes model to predict this, but it's essentially impossible to do this with 100% accuracy.

The principle of how this spread can return a profit is relatively straightforward. Near term options will typically lose their time value at a faster rate than longer term ones. As such, in theory at least, the near term contracts that you write should fall in price more quickly than the contracts that you own.

The idea is that, assuming the price of the underlying security hasn’t moved, just before expiration, you buy back the options written. You should then be able to sell the ones that you own, and make a profit overall. Alternatively, you can simply let the options written expire worthless. Using the above example provided, we have shown below how this might work.

• The price of Company X stock is at exactly $50 by the time the options written in Leg A expire. As such, they expire worthless. The longer term options you have bought in Leg B are still at the money, but they should have retained most of their time value.
• If the options bought in Leg B are trading at $2.50 each, you could sell them all for $250. After taking into account the initial investment of $200, you have made a $50 profit.
• If the options bought in Leg B are trading any higher, then your profits would be greater.
• Assuming the options written in Leg A have expired worthless, profit can be calculated as “Total Value of Options Bought in Leg B: Initial Net Investment”

If the underlying security increases in value, then the calls written in Leg A could be assigned and leave you with a liability. However, you could then exercise the ones bought in Leg B to buy the underlying security at the same price you are obliged to sell it at. Your losses would therefore be limited to the initial cost of establishing the spread.

If the underlying security fell in price, then the options written in Leg A would still expire worthless so you would have no liabilities. The price of the ones bought in Leg B would depend on how much the price of the underlying security fell. You would likely still lose money, but you should be able to sell the options you own to at least recover some money and reduce your losses. The absolute maximum you can lose is the net spent at the time of establishing the spread.

Alternatives

The calendar call spread can effectively be replicated by using puts instead to create a calendar put spread. You can also create the calendar call spread as a diagonal spread, by buying calls with a lower strike than the calls you write.

The basic principle when using a diagonal spread is essentially the same, but it will cost a little more to put on, and you will make more money if the price of the underlying security rises slightly.

Summary

This is a good strategy for trying to profit from a security staying stable in price, while limiting losses if the security in fact moves up or down in price. The principle is quite simple, because you are basically just trying to profit from the effects of time decay.

The biggest disadvantage is that it's difficult to forecast how much you might make with complete accuracy, because you cannot precisely predict exactly how the options prices will be affected by time decay.