Understanding Calendar Spreads

An option strategy that works well for those want to take advantage of time value is calendar or time spreads. It is also a good strategy in a low volatility environment. With the MX Volatility Index at 15.35% and well below its 200-day moving average there is a good argument in support of the position that volatility is low.

The calendar spread involves the purchase of a longer term call option combined with the sale of a shorter term call option. You could also use puts in a calendar spread, but the key with the strategy, is that both options have the same strike price.

You could create a calendar spread on the iShares S&P TSX 60 index fund (symbol XIU, Fridays close $17.77) by selling, say, the XIU March 18 calls at 35 cents, and buying the XIU March (2013) 18 calls at $1.45. Both options are calls with the same strike price. The difference, and why we call it a calendar spread, is the expiration months. The short call expires in two months (March 2012) while the longer term call expires in 14 months (March 2013).

The calendar spread has an out-of-pocket cost. You will always pay more for the longer term call than you receive for the call you are selling. In the XIU example, the difference is $1.10. For margin purposes, the call you bought effectively covers the sale of the short option. From a risk perspective, the most you can lose from a calendar spread is the net debit (in this example, $1.10).

In some ways the calendar spread is like a covered call, with the longer dated option being a surrogate for shares of the underlying stock. But what really makes the calendar spread appealing is the certainly of time value erosion. The closer the option gets to expiration, the faster time value erodes, eventually falling to zero, if at expiration, the short option is out-of-the-money.

The value of the March 2012 options which expire in 8 weeks will erode at a much faster rate than the March 2013 options expiring in 14 weeks. That is a mathematical certainty. In fact, the short options time value will erode about three times faster than the longer dated option assuming the underlying stock remains in a relatively narrow trading range.

If XIU is at or below $18 at the March 2012 expiration, this position will almost certainly be profitable. Why? Because at the March 2012 expiration, the March 2013 options will still have 12 months to expiry and assuming XIU at $18, would be worth about US $1.50. The net cost for the spread was $1.00 and you are now long March 2013 calls worth $1.50.

But time value erosion is not the only thing that makes of this trade interesting. A low volatility environment enhances this trade because changes in volatility have a bigger dollar value impact on the longer term option. If volatility should rise and the underlying stock still remains in a relatively narrow range, this trade would generate a profit.

For example, the prices used in the XIU example assumed a 15.35% implied volatility. But suppose we applied a 25% implied volatility assumption to the options when the position was established (i.e. with XIU at $17.77 per share). At a 25% volatility assumption, the March 2012 call premiums would be 60 cents versus $1.85 for March (2013) 18 calls. In this case, the difference would be $1.25 instead of $1.10.

There are risks of course. If the underlying stock should rise or fall significantly, the calendar spread will lose money. That’s because time takes a back seat to the relationship between the strike price and the underlying stock price. In short, should the stock advance sharply (assuming we are using calls to create the calendar spread), the short term option will rise at a faster rate than the longer term option.

That mathematical quirk is what makes the calendar spread different from a covered call strategy. With a covered call strategy volatility has no impact on the value of the underlying security.

Ideally when using calendar spreads, you want the underlying stock to remain in a trading range, until the near month option expires. The XIU calendar spread should be profitable if the price of the stock remains between US $17.25 and $18.35 until the March 2012 expiration. Above or below that range, the position will experience a slight loss, assuming volatility remains unchanged. But again, the potential loss is limited to the net debit paid.

Generally, you would not likely lose the entire net debit. As long as the March 2013 option had time remaining it should have some time value. Even if the underlying stock were to drop sharply, volatility would spike, which would benefit the longer term call.