Short Calendar Call Spread

The short calendar call spread is an options trading strategy for a volatile market that is designed to be used when you are expecting a security to move dramatically in price, but you are unsure in which direction it will move. There are actually two variations of this strategy: the short horizontal calendar call spread and the short diagonal calendar call spread.

The short horizontal calendar call spread is the more commonly used and that's the variation we have focused on here.  Although we have also provided a brief explanation of how the short diagonal calendar call spread differs. Please see below for full details on how and when to use this options trading strategy.

The Key Points

  • Volatile Strategy
  • Not Suitable for Beginners
  • Two Transactions (buy calls and write calls)
  • Credit Spread (upfront credit received)
  • Medium Trading Level Required
  • Also known as – Short Call Calendar Spread, Short Time Call Spread

When to Use a Short Calendar Call Spread

As stated above, the short calendar call spread is designed specifically to be used when you believe that a security is going to move in price quite significantly, but you aren't sure in which direction the move will be. Such a scenario might occur when a publically listed company is about to release its annual earnings, because that can often lead to a big swing in its stock price.

Rather than spending a great deal of time researching and studying to try and determine whether the price swing will be positive or negative, you can simply use this strategy. It will result in a profit regardless of which way the price moves, providing the move is a significant one.

How to Use a Short Calendar Call Spread

Establishing a short calendar call spread is actually reasonably straightforward, although it's not a strategy we recommend for beginners. There are just two transactions involved: buying at the money calls and writing at the money calls. Because it's a calendar spread, you need to use different expiry dates for the two transactions.

The options you buy should be short term, meaning the expiration date is relatively close, while the ones you write should be long term with a more distant expiration date. You should buy the same amount of contracts as you write and, as the longer term ones will be more expensive, you'll receive more money than you have to spend, resulting in a net credit.

We’ve provided a basic example of the short calendar call spread below, to illustrate how it can be established. For the sake of keeping things simple, we’ve used hypothetical prices rather than real market data and ignored commission costs. We then go on to explain in what circumstances the strategy will return a profit and in what circumstances in will result in a loss.

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

Potential for Profit & Risk of Loss

Unlike many other strategies, it's difficult to calculate the exact profit and loss potential of this spread. As the options you buy have the same strike as the ones you write, any changes in the price of the underlying security will have the same effect on the intrinsic value of both sets of options.  So this the strategy works on the basis of changes in the extrinsic value of options (affected by time decay and implied volatility).

The basic principle is that you will profit from changes in the extrinsic value if the price of the underlying security moves sharply in either direction. This should result in the extrinsic value of both sets of options reducing dramatically, but the extrinsic value of the longer term ones will reduce at a faster actual rate than the extrinsic value of the shorter term ones.

What this means is that the difference in the extrinsic value between the options you own and the ones you have written should come down to close to zero. If the underlying security has gone up dramatically in price, then both sets of options will be made up almost entirely of intrinsic value and should be a very similar price. You can then sell the ones that you own and buy back the ones that you wrote and your profit should be close to the initial net credit you received.

If the underlying security has gone down dramatically in price, then there will be very little extrinsic value in either set of options. When this is the case you can let the ones that you own expire worthless and then buy back the ones that you have written to close your position. Providing you can buy back the ones written for less than the initial net credit, you will make an overall profit.

The risk is that the price of the underlying security remains relatively stable. This could result in the options that you own expiring worthless, or close to worthless, while the ones written could still have significant extrinsic value. You would then have to buy those back to close your position and this would result in a loss.

If the options you own do expire worthless, it's very important that you buy back the options written immediately, otherwise you will be left with a short call position and exposed to potentially unlimited losses.

Short Diagonal Calendar Call Spread

This spread works on a similar basis, but you would buy options that are out of the money (while still writing options that are at the money). As the out of the money options are cheaper to buy, the initial credit received is higher and so the maximum profit is increased. However, if the underlying security increases in price, the intrinsic value of the options written will be higher than the intrinsic value of the options bought which could result in a loss.

Summary

This strategy does have some advantages. As a credit spread there's no upfront cost for establishing the strategy, although margin will be required. It also has a good risk to reward ratio as the maximum profit is typically greater than the maximum loss.

However, it's difficult to accurately forecast the exact effect of time decay and volatility on the price of options, which makes it hard to calculate exactly what the potential for profit and loss is. This is why we don’t recommend this strategy for beginners and we would suggest that only traders familiar themselves with the Black Scholes options pricing model and use it.