An eye on the calendar

  • The options “calendar spread” is designed to capitalize on time decay
  • Position combines short nearby option with long, more-distant option
  • Volatility relationship between the two options also key

A stock is trading at $50.35. A trader sells a $50 call expiring in three weeks while simultaneously buying a $50 call expiring a month later. The short option presents the risk of having to sell the stock at $50, while the long option confers the right to buy it at $50.

While it may sound like a wash, longtime options traders will recognize this position as a “calendar spread”—which, as the name implies, is designed to take advantage of the differences in how time affects options with different expiration dates. Specifically, this position is an at-the-money (ATM) calendar spread because the option strike prices and the underlying stock price are nearly the same.

As noted in “Labor jolt highlights options,” while all options lose value over time, that time decay accelerates toward the end of an option’s life, particularly the final two to three weeks. That means, all else being equal, an option that is closer to expiration will lose more value than one with the same strike price that is further from expiration.

The underlying logic of the calendar spread is to short something that could lose a significant portion of its value in a certain period of time, while buying something with the potential of holding onto more of its value. When you liquidate both sides of the trade, hopefully you’ve made more on the short option than you’ve lost on the long option.

Although ATM calendar spreads can be constructed using calls (if a trader is more bullish than bearish on the underlying stock) or puts (if the opposite), the position’s risk-reward profile shows that the trade’s potential profit diminishes if the stock makes a big move, up or down:

Chart 1: At-the-money (ATM) calendar spread. Options calendar spread profit-loss profile, risk-reward profile. Potential profit greater with steady stock price.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)

To understand how this trade is designed to work, let’s look at how two options with the same strike price but different expirations recently performed. On September 13, Coupang (CPNG) closed at $30.52:

Chart 2: Coupang (CPNG), 9/3/21–11/4/21. Coupang (CPNG) price chart. Back to $30.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)

Let’s say a trader built an ATM calendar spread by shorting the November $30 call for 2.84 (it’s closing price on September 13) and buying the more-distant December $30 call for 3.20, which means it would have cost 0.36 to put on the trade, and is also its maximum risk.

On November 3, CPNG closed at $30.42—virtually unchanged from where it was on September 13. Meanwhile, the November $30 call had fallen 1.04 to 1.80, while the December $30 call had fallen only 0.95 to 2.25—meaning, the November call had lost nearly 9% more time value than the December call.

Of course, the small difference in this example is one of the reasons traders using calendar spreads try to short options that are much closer to expiration (e.g., in the final weeks before expiration), since their accelerated time decay increases the trade’s potential profitability.

The other thing some calendar-spread traders attempt to do is short options with higher implied volatility (IV) while buying those with lower IV, since an option with higher volatility is potentially overpriced—which means the trader shorting it collects more premium. The LiveAction scan for stocks with higher IV in the nearby expiration month (Expiry1) than in the next expiration month (Expiry2) is one way to find options that may have this relationship

Chart 3: LiveAction scan: Expiry1 IV > Expiry2 IV, 11/4/21. Options implied volatility. Nearby IV much higher than next month’s

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)

In any situation, it’s helpful to understand why IV might be notably higher or lower in one expiration vs. another, since today’s volatility may not be tomorrow’s volatility. For example, Opendoor Technologies’ (OPEN) November options IV (Expiry1) was around 50% higher than its December options IV (Expiry2)—possibly a function of the company’s upcoming earnings announcement (currently scheduled for next week), as well as the fact that the stock has made double-digit percentage price swings two out of the past three days.

A final note: Unlike many other multi-leg options strategies, the calendar spread’s separate expiration dates means it’s not a “set it and forget it” type of trade. Once the nearby (short) option expires, the trader is left with an outright position in the more-distant (long) option that has its own risks and potential rewards. Unless the trader decides the long option has some advantage (perhaps because of some unforeseen market development), the basic calendar-spread exit technique is to buy back the short option for as little as possible (or letting it expire worthless) while simultaneously selling the long option.

In other words, traders have to keep their eyes on the calendar.

Today’s numbers include (all times ET): Employment Report (8:30 a.m.).

Today’s earnings include: Johnson Controls (JCI), Honda Motor (HMC), DraftKings (DKNG), Canopy Growth (CGC).


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