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 PRICE. The 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.