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The calendar spread options strategy

Here's how to capture opportunities created by volatility with the calendar spread.

  • Fidelity Active Trader News
  • – 12/11/2013
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There were a few bumps in the market during 2013, but overall it was a relatively calm year by historical standards. U.S. stocks have experienced modest volatility as the Volatility Index (VIX) has remained below 21 all year. In comparison, 2012’s high was 26 and the all-time VIX high was 89.53 during the financial crisis of 2008.

But what if volatility does start to pick up? The calendar spread options strategy is one way that seasoned options traders can potentially capitalize on expectations for a particular stock to have different levels of volatility at varying points in time.

What is a calendar spread?

A calendar spread typically involves buying and selling the same type of option (calls or puts) for the same underlying security at the same strike price, but at different expiration dates. This type of strategy is also known as a time or horizontal spread due to the differing maturity dates.

A typical long calendar spread involves buying a longer-term option and selling a shorter-term option that is of the same type and exercise price. An example would be buying a 40 XYZ call option with an expiration date of December 2017 and simultaneously selling a 40 XYZ call option with an expiration date of December 2014. This is a debit position: You pay at the outset of the trade.

Calendar spreads are for experienced, knowledgeable traders

In technical terms, the calendar spread provides the opportunity to trade horizontal volatility skew (different levels of volatility at two points in time) and take advantage of the accelerating rate of theta (time decay), while also limiting exposure to delta (the sensitivity of an option's price to the underlying asset). The horizontal skew is the difference of implied volatility levels between various expiration dates.

The goal of a calendar spread strategy is to take advantage of expected differences in volatility and time decay, while minimizing the impact of movements in the underlying security. The objective for a long call calendar spread is for the underlying stock to steadily decline over the short term and then move higher during the life of the longer-term option, and for there to be an increase in implied volatility (IV). IV is an estimate of a security’s volatility.

Calendar spread candidates

You can use some of the tools that are available on Fidelity.com to search for calendar spread opportunities. For example, if you select “IV 30 > HV 30” as the criterion, the scan will look for elevated IV levels relative to historical volatility (HV) levels. This specific screen may indicate that certain options are “expensive.”

In mid-October, one result of such a scan was Monster Beverage Corporation (MNST), which was trading at $57.58 at the time, with an earnings report due soon. Based on this scan, you might have sold the November 2013 52.50 put for $0.70 and bought the January 2015 52.5 put for $6.45, for a total cost of $575.

The IV level of the November put was 43.16%, with a vega of 0.0413, while the January 2015 put reflected an IV level of 35.55%, with a vega of 0.2324. Vega measures an option price’s sensitivity for a given change in implied volatility. With the earnings report approaching, the IV level of the front month was above its normal IV in anticipation.

After earnings, it would not be unusual for the IV to normalize to a similar level as that of the long “leg” (each side of a spread is referred to as a leg), which would be in line with historical levels. This IV change would reduce the theoretical value of the options by $0.31 per contract. Usually, the longer-term contract IV levels are less sensitive to price movements in the underlying short-term security.

Theta also works in favor of the calendar spread. Theta for the November contracts in the chart below shows that the option’s theoretical value is being reduced 0.0374 with each passing day. This compares with the January 2015 contract, which shows that the theoretical value will be reduced 0.0093 per day. The fact that the short-term contract decays more quickly benefits this strategy.

Profit/loss breakdown

The profit/loss diagram of a calendar spread shows that when the stock price increases, this type of trade suffers. Significant movement in either direction in a short period may be costly because of the way the higher gamma (the rate of change, or sensitivity, to a price change in the underlying security for delta) affects short-term contracts.

Another risk to this position is early assignment when selling shorter-term contracts (especially with calls), where the expiration date follows the ex-dividend date. If this is the case, the probability of assignment increases significantly. If assignment occurs prior to the ex-dividend date, the client will owe the dividend payment because the account is now short shares, unless shares of the underlying security are already held in the account.

Early assignment also changes the strategy from a calendar spread to a synthetic long put if you don’t already own shares, because you are short a stock and long a call, which is a very different outlook.

Managing a calendar spread

The profit and loss calculator at the time of this hypothetical trade showed that the breakeven points were 48.14 and 58.95 for the November expiration. When placing the calendar spread, monitoring the security price and the delta levels can be pivotal to success. You can do this by setting alerts in Active Trader Pro® or on Fidelity.com.

It is also advisable to check for ex-dividend dates, as it is very important to understand assignment risk—especially for call spreads. You can adjust the spread as necessary to maintain the long position, while adjusting the strike price of the short contract along the way to give more delta exposure.

Calendar spreads with Fidelity

A client needs at least a "level 3" option approval to implement this strategy.

When the short-term expiration date approaches, you will need to make a decision: Sell another front-month contract, close the whole strategy, or allow the long-term put to stay in place by itself.

Learn more

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Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. Prior to trading options, you must receive from Fidelity Investments a copy of "Characteristics and Risks of Standardized Options" and call 1-800-343-3548 to be approved for options trading. Supporting documentation for any claims, if appropriate, will be furnished upon request.
There are additional costs associated with option strategies that call for multiple purchases and sales of options, such as spreads, straddles, and collars, as compared to a single option trade.
Greeks are mathematical calculations used to determine the effect of various factors on options.
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