I make no bones about it: The calendar spread is one of my favorite option trades. Like many option strategies, it can be used short term and long term as well as for a bullish, bearish or neutral outlook on the underlying. That is hard to beat in my opinion, but let’s take a closer look at the calendar spread and long calendar option strategies in particular.
What Is a Long Calendar Spread?
A long calendar spread is selling an option and buying a longer-term option with the same strike. Generally, the trader uses all calls or all puts. A calendar is a time spread because it benefits from the passing of time. The short option will have a bigger positive theta than the long option, which will have a smaller negative theta. The maximum profit is realized if the stock closes right at the strike price of the short expiration. That option expires worthless and the long at-the-money (ATM) option will have time premium left. The max profit and the break-evens are all hypothetical because there are two different expirations. Using the P&L (profit and loss) diagrams your broker likely provides is the best way to estimate them.
Just for sake of definition, a short calendar would be if an option trader sells the option with the longer expiration and buys the shorter expiration. In this case, the short option would essentially be “naked” because of the longer expiration.
In addition to positive theta, directional long calendars may also profit from delta. If a calendar is above the current underlying price, there is positive delta, which can increase the spread’s premium. If the calendar is below the underlying price, there is negative delta. A move lower would be beneficial.
How to Create a Calendar Spread
The key component to the trade being successful is where the underlying ends up at the short-term expiration. Whether it is neutral or directional, the key is choosing the strike that is closest to where you think the underling will end up at Friday’s expiration. I like to look at these trades as positive theta trades that can offset some delta if the underlying does not act as anticipated. That is why the P&L diagrams are estimates but with wiggle room too.
Another potentially key component that can enhance potential profits is an implied volatility skew. An option trader prefers to sell higher IV and buy lower IV. For the long calendar, a higher IV is naturally preferred on the short option with a lower IV compared with the short strike on the long farther out expiring option. This scenario is not mandatory but gives the option trader an edge. With an IV skew, the cost is cheaper, potential max profit is greater and break-evens are potentially wider too. Let’s take a quick look at an example.
Calendar Spread Example
With the underlying trading just over $25, an option trader believes the stock will remain around that level for the next week or so because of a channel it has been trading in. There is an IV skew as seen below with the short option having an IV just over 76% and the following week’s long option having an IV just over 68%. Call options were sold and bought for this long call calendar. The calendar is purchased for 0.36 (1.51 – 1.15).
Notice the position has a neutral delta (0.54 – 0.54) with the stock trading close to the strike price of 25. The position also has positive theta of 0.02 (0.07 – 0.05) currently. As time passes and if the underlying hangs around the $25 level, that positive theta will increase. More will be subtracted off the short option than the long option, which will increase the overall premium. If the stock veers from the $25 level, delta will become either positive (lower than $25) or negative (higher than $25). Positive theta will be able to offset some of the delta loss provided the underlying does not stray too far.
Take a look at the P&L diagram below and its estimates. At the short expiration, it is estimating the break-evens will be around $23.50 and $26.75. The max profit estimate is just below $60 at expiration. Positive theta and the IV skew make this P&L diagram attractive even if the underlying moves a little away from $25.
Wrapping Up Calendars
Long calendars can be an option trader’s best friend. They are very versatile and offer some wiggle room if the outlook is not exactly on point. These days, we all can use a break or two.
Senior Options Instructor
Market Taker Mentoring, Inc.