Thursday, 7 April 2016

INTRODUCTION TO CALENDAR SPREADS

TIME SPREADS
DEFINITION: A calendar spread is a position with two options; buy one option and sell another. Both options are calls or both are puts, with the same underlying asset and strike price, but different expiration dates.  Buying the option that expires later, is BUYING the calendar spread.  Buying the option that expires earlier, is SELLING the calendar spread. Traders almost always buy calendars because the margin requirement is steep for sellers (For margin considerations, the short option is considered to be naked, or unhedged). 
At one time, it was common to refer to calendar spreads as 'time spreads.'
Example 
     Buy 10 IBM Jul 18 '14 100 calls
     Sell 10 IBM Jun 20 '14 100 calls
The calendar is commonly used when the trader believes that the:
·         Underlying stock will be priced near the strike price at, or near, expiration. 
·         Implied volatility of the longer-term option will increase over the lifetime of the trade.
Note: The options do not have to expire in consecutive weeks or months.
The distance between expiration dates is immaterial; the only requirements for a calendar spread are that the underlying asset and strike price are identical.
How does the calendar earn a profit? 
The calendar spread takes advantage of the fact that options with shorter lifetimes decay more quickly than options with longer lifetimes. Thus, all else being equal, as time passes both options lose value, but the spread value increases.
The world is not quite that simple.  If the rate of time decay were the only factor, calendars would be profitable almost all the time.  Other factors affect the calendar spread. The two primary factors are:
1. STOCK PRICEThe calendar reaches is highest value when the underlying stock is priced exactly at the strike price as expiration arrives. The data in the table below illustrates the point.
ASSUMPTIONS: IBM is $XXX per share; date: Jun 18, 2014, 4:00 PM ET;  Implied Volatility is 45.
NOTE: When IBM is $100 or less, the Jun 100 call expires worthless and the value of the Jul 100 call is the value of the calendar spread.
When IBM is above $100, the Jun call is in the money.  For the values in the table, assume that the IBM Jun 100 call is bought at parity (the option's intrinsic value, or the amount by which it's in the money) and the IBM Jul 100 call is sold at it's value.
 
IBM Price 
 88
 92
 96
100
104
108
112
Jun 100
$0.00
$0.00
$0.00
$0.00
$4.00
$8.00
$12.00
Jul 100
$0.93
$1.80
$3.13
$4.97
$7.32
$10.13
$13.31
 
 
 
 
 
 
 
 
Spread
$0.93
$1.80
$3.13
$4.97
$3.32
$2.13
$1.31
 Look at the data in the bottom row.  The value of the spread is highest when the stock is near the strike price and steadily decreases as the stock moves away from the strike in either direction.
Thus, when trading calendar spreads, it's advantageous to have an idea where the stock price is headed. For traders who are uncomfortable predicting such outcomes, I do not recommend trading calendars. 
2. IMPLIED VOLATILITY
The Table below is similar and shows the value of the spread when IBM is $100 at expiration and implied volatility varies. This time the maximum value occurs when IV is at its highest level.

 Implied Vol
   30
   35
  40
 45
  50
  55
 60
Jun 100
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
Jul 100
$3.32
$3.87
$4.42
$4.97
$5.53
$6.08
$6.63
 
 
 
 
 
 
 
 
Spread
$3.32
$3.87
$4.42
$4.97
$5.53
$6.08
$6.63
 

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