The secret behind Calendar Spread

In one of our previous blogs, we have explained what is calendar spread and how to trade calendar call spread. In this blog, we are going to discuss how we can make use of the calendar spread strategy efficiently and incorporate it into our portfolio. We are also going to discuss the secret behind the calendar spread.

This blog covers,

What is Calendar spread?

Types of calendar spread strategy

Analyzing Calendar spread options strategy

Secrets of Calendar spread strategy

What is Calendar spread?

A calendar spread is a strategy that involves simultaneous buying and selling two calls or two puts of the same strike price but with different expiration. The calendar spread strategy is conservative slow-moving vehicles that try to capitalize on the accelerated theta (θ) in the front expiration and the larger Vega in the back expiration. This creates a strategy that is both positive theta and positive Vega while aiming for the underlying to stay inside a price range. Now that we have seen what is calendar spread let’s see it types.

Types of calendar spread strategy

Following are the different types of calendar spread strategy that one can incorporate into the portfolio,

1. Call calendar spread strategy

2. Put calendar spread strategy

Analyzing Calendar spread options strategy

Let’s analyze these strategies one by one,

1. Call Calendar spreads:-

This calendar spread options strategy has long calls and short calls. This strategy involves buying a call of a certain strike price and of the front expiration and selling a call at the same strike price but with back expiration.So in this calendar spread strategy, we're going to have a short call on the front expiration and we're going to have a long call on the back expiration. If we put them together, we're going to have a calendar spread with calls.

2. Put Calendar Spread:-

Put calendar spread options strategy is the exact same thing as call calendar spread strategy but it is with the puts. Here one has a long put in the back month expiration and a short put on the front month expiration at the same strike price and is called as having a calendar spread with puts.

Trade Dynamics

When trading long calendar spreads, we expect the stock price to trade near the strike price as time passes. If it does, the front-month (short option) will decay faster than the longer-term long option. This is what we intend and will result in profit.

As time passes, the short option will lose more value than the long option, generating profits for a long calendar spread trader.

Secrets of Calendar spread strategy

Because calendar spreads (long ones) are Vega positive (the bought option implied volatility is greater than the Vega of the short option, resulting in a net positive Vega position) there is a general idea that when there is a Volatility increase the Calendar spread strategy will benefit.

This could happen if the overall IV of the market increases. This is observed in small market corrections. But, for the novice trader, it could be expected that since the longer-term option has a higher Vega than the front-month option, that the long option would gain more value than the short option when implied volatility increases.

Theoretically, this could happen but practically this tends to not occur. Especially in high IV spikes, the short-term and long-term IV do not change in tandem, meaning at the same rate.

When there is a huge volatility spike, the IV of the near-term option rises faster than the longer-term one. This is, in fact, a good situation to buy calendar spreads due to the high IV of the near-term option (higher at the moment) and buying lower IV of the longer-term option.

Near-term option IV will decrease faster than the other and profits will be captured. When there is this IV skew between option chains under backwardation and high IV environment, it is time to buy Calendar Spreads.

So, despite the fact that long calendar spreads trade with positive Vega; they could lose money from an increase in IV, although they are Vega positive, in case of a fast IV spike.

Calendar spreads have positive Vega; nevertheless, they perform best under high IV (especially under backwardation)

Conclusion

Calendar spreads have positive Vega; nevertheless, they perform best under high IV (especially under backwardation). Calendar spreads strategy is built with different options chains whose Implied Volatility (IV) moves independently. Hope this blog has given you enough guidance upon what is calendar spread? and calendar spread options strategy.