*This article was originally published in The Option Strategist Newsletter Volume 13, No. 7 on April 9, 2004. *

The calendar spread is an interesting strategy, for it allows one to profit in two ways: 1) if the stock moves near the striking price of the spread at expiration and 2) if implied volatility increases (and the stock is at least within “shouting distance” of the striking price). In addition, if there is a discrepancy in the prices of the options when the spread is established (i.e., a horizontal skew exists), that may contribute to the profitability of the spread as well. Unfortunately, there are drawbacks to the calendar spread strategy as well. So, in this article we’re going to look at some variations of the strategy that may improve its profitability. One such variation is to use more than one calendar spread on the same underlying at the same time. If two spreads are used, it’s called a “dual calendar spread.” We’ll look at that strategy and then expand upon it as a general approach to calendar spread trading.

The basic calendar spread is established by buying an intermediate- or long-term option and selling a shorter term option against it, where the two options have the same striking price (and, of course, have the same underlying instrument). The spread can be established with either puts or calls, although it is more common to see it done with calls – for reasons we’ll explain in a minute. When operated as a pure spread strategy, one looks to remove or adjust the spread when the near-term options expire. It is not and should not be the intent of the spreader to hold onto the longer-term option as a speculation after the near-term option expires. Of course, there are always exceptions to these general rules, but as a strategist, the philosophies outlined above should be the ones you pursue as a calendar spread trader. The basic profitability of a call calendar and a put calendar, using the same striking prices on the same underlying are shown in the graphs below.

The above graphs use the following theoretical prices:

Stock: 100; Strike price = 100 May July Call 7.00 10.60 Put 6.80 10.10

Note that at today’s low levels of interest rates, the puts sell for nearly the price of the calls. If interest rates were to rise, there would be a larger discrepancy between the put price and the call price.

Both spreads have some similar characteristics. First, the risk is the debit paid for the spread – nothing more (of course, it is 100% of the money you invested in the spread, so one must be careful not to over-leverage himself with calendar spreads). Second, when the nearterm option expires (which is the time at which these profit graphs are drawn), the maximum profit occurs if the stock is exactly at the striking price of the options. Third, there is a range within which a profit can be made.

One difference in the graphs is that the call spread has a larger profit potential than the put spread – in dollar terms, but not necessarily in percentage terms. Another subtle difference is how the graphs look on the “tails” – especially on the downside. Notice how the put graph flattens out at the maximum loss quite quickly at prices below 80, but the call graph does not. This is because inthe- money puts trade at parity much more quickly than similar calls do.

In any case, the spreads are similar enough that we can consider using one or the other somewhat interchangeably if we decide to combine them. Notice that both spreads have a profit range that is approximately between 90 and 113 at expiration. If the stock is between those two prices at May expiration, a profit should result, assuming that the implied volatility of the July option has stayed the same or risen. Even if it has fallen, there might still be a profit, but the range over which such profits would exist would be narrower than the one shown on the graphs.

Many times, a trader who is interested in a calendar spread will find the spread’s potential risk/reward attractive, but is not happy with the width of the profit range – figuring that there is just too large of a chance of the stock finishing outside of that profit range. This is where a dual calendar spread might help.

Let’s use the same example, but expand it somewhat. Suppose that the following prices exist, in addition to the ones shown previously (the stock is still trading at 100).

Strike May July 110 Calls: 3.40 6.80 90 Puts: 2.70 5.50

Furthermore suppose that we decide to combine these two calendar spreads in a trade:

Buy the July-May 110 call spread for 3.40 debit and Buy the July-May 90 put spread for 2.80 debit.

The total debit for this spread would thus be 6.20, plus commissions – and that is the risk incurred. The profit graph of this combined picture is shown below.

There are two obvious features. One is that there are two peaks in the graph – one at each strike. Furthermore, the peak at the call strike (110) is higher than the peak at the put strike (90). This is a fairly common occurrence when combining puts and calls in a dual calendar spread strategy. If you would prefer to even out the profit potential at each strike, then you would establish more put spreads than call spreads – in a ratio of about 3 put spreads to 2 call spreads.

Notice also that the maximum profit potential of this spread is slightly lower than that of the individual calendar spreads shown on page 2. However, there is a compensating factor: the profit range is now wider, extending from about 86 to 119. So the dual calendar has the benefit of a wider range, which – in a certain sense – is obtained by accepting a lower profit potential. This is a good tradeoff, in my opinion, because it’s unlikely that one will realize the maximum profit potential from a calendar spread anyway.

How valuable is it for the profit range to have widened by that much? It’s dependent on the volatility of the underlying, of course, but assuming that XYZ stock has a volatility of 50% in the above examples, here are the probabilities, as calculated by our Probability Calculator 2000: the probability that the stock will finish between 90 and 113 is 44%. The probability that it will finish between 86 and 119 is 58%. Hence the use of the dual calendar spread certainly turns the odds of making a profit in your favor.

Note: the reason that we use a put spread and a call spread, rather than two different call spreads, say, is to reduce the possibility of early assignment. If we establish the position with out-of-the-money options, the early assignment risk is diminished. Of course, early assignment doesn’t ruin the strategy, but it does incur additional commission and margin expenses, and is generally something that a calendar spreader would rather avoid.

Some traders take this concept even farther – using a series of calendar spreads as adjustments. For example, what do you do if the underlying stock suddenly shoots higher while you have a calendar spread in place? You could just sit tight, hoping for a price reversal back towards the original striking price. But suppose, you view the chart and see that an upside breakout has occurred? Is there a way to “repair” the strategy? I am actually not big on the “repair” concept, but there are adjustments that can be made.

One might be to add some long delta to the position – say by buying back some of the short calls (which are now presumably in-the-money), or if premium levels are high the sale of some out-of-the-money puts might be a reasonable approach. One would probably make that choice at least partially on how expensive the options are.

But there is another choice if implied volatility is still relatively low – lay another calendar spread on top of the position. This will produce yet another peak on the chart and would add some additional profit potential if the stock stabilizes. Of course, it also adds more debit to the position, which is at risk if the stock continues its upward climb.

Let’s continue the above strategy one more step. Suppose that you had originally established the dual calendar spread with XYZ at a price of 100. Suddenly, XYZ makes a strong move to 120, and the following prices exist, two weeks after the initial trade was established:

XYZ: 120 Strike May July 120 calls: 7.00 11.90

So, if we add this spread – at a debit of 4.90 – to the position, it now has a profit graph that looks like this at May expiration:

There are still 3 peaks on the graph, although the one at 90 – the striking price of the put spread – has now dropped below the profit line because of the relatively large debit incurred by this new spread. Notice that the breakevens now move up, to about 105 and 126 (from 86 and 119, respectively). This is good in that it means the entire position can now profit if the stock stabilizes in the current area. However, there is no longer any chance to make a quick profit, as the curved line (“In 14 days”) shows. Also, the entire debit has increased, so that a total of $1110 is now at risk, if the stock continues to rise.

Overall, this is a reasonable approach to calendar spreading – to continue to lay on new calendars as new striking prices are reached. I think it is best used when the underlying is not trending strongly, but is more likely creeping up to new strikes. In a strong trending move, neutrality should be acquired by the previously-mentioned strategies of either buying calls or selling puts. I met one trader who uses this strategy on QQQ options – laying out calendar spreads at each strike along the way as QQQ moves up and down. I’m not sure if he’s actually helping his profit potential by doing this, but one can see that if the stock eventually starts to go sideways, the “last” calendar spread will profit and gain back some of the losses from the other spreads. If one can envision the profit graph of such a spread – with peaks at each strike – we could call it the “Denver airport spread.” If you don’t get that, then you’ve never seen the new Denver airport.

In summary, a calendar spread strategy can be improved by 1) initiating a dual calendar spread to widen the profit range, and 2) adjusting the spread if it begins to lose money (i.e., if it acquires an overly large positive or negative delta). The adjustment, if necessary, could be just a simple option purchase or sale if the stock is trending, but could also be accomplished by laying on another calendar spread if the stock is not moving in a volatile manner.

*This article was originally published in The Option Strategist Newsletter Volume 13, No. 7 on April 9, 2004. *

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