Spreads: calendars

In short

A friend of mine once told me that time is the one thing in the market you can neither hurry nor hide from. A calendar spread puts that idea to work. You sell an option that expires soon, and you buy an option at the same strike price that expires later. The near term option loses value faster than the far one, and that gap is what the position is built around. You pay a net cost to open it, and that cost is the largest amount the position can lose, though fees, early assignment, and your broker's handling of the leg that stays open can add costs. If you are weighing one, check how your broker treats the far leg once the near leg expires. Read the options disclosure document, because the risks are written plainly there.

The whole of it

What it is

I once watched an old farmer sell next month's eggs and keep his best hens for the spring. That is not a bad picture for a calendar spread, though the hens are options. You have probably heard of a call option, which is a contract giving you the right to buy a stock at a set price. A put is the mirror image, the right to sell. A calendar spread, also called a time spread or horizontal spread, uses two of the same kind. You sell one that expires soon and buy one that expires later. Both share one strike price, which is the price written into the contract.

Why bother? You have likely noticed that an option's price has two parts. One part is what the option would be worth if exercised today. The other part is time value, the extra a buyer pays for the chance that things will change before expiration. Time value shrinks as expiration draws near. The near contract loses it fast. The far contract loses it slowly. You own the slow one and owe the fast one. Simple as that.

A friend of mine calls this position a long calendar when you pay to open it, since the far option costs more than the near one. A long calendar has a capped loss, which makes it easier to sleep on than many other option trades. Capped does not mean safe, as you will see below.

How it works

If you are holding a long calendar, you have paid a net debit. That is the far option's price minus the near option's price. The debit is the most the position itself can lose, not counting trading commissions, fees, and any costs that come from early assignment.

Now picture where the stock goes. I have noticed the spread tends to do best when the stock sits near the strike price as the near contract expires. Why? Then the option you sold is nearly worthless, and you keep that gain. Meanwhile the option you bought still has months of time value left in it. The gap between the two prices has widened in your favor.

If you have ever watched a stock run far above or far below the strike, you know what comes next. Both options move toward the same price, and the gap closes. Then the spread loses value. So the trade is a bet on calm, not on direction. A calendar spread likes a stock that stays put.

There is another piece, and it matters to anyone who wants the whole picture. Implied volatility is the market's guess at how much a stock will swing. When that guess rises, option prices rise, and the far option rises more than the near one. So a long calendar often gains when implied volatility goes up and loses when it falls. You are paying for time, but you are also holding a view on those swings, whether you meant to or not.

If you are sitting at the near option's expiration, you have choices. You can let it expire and keep the far option. You can close everything. Or you can sell a new near option against the far one, which is called rolling. Each choice has costs, so count them first.

The numbers, and where to find yours

You will want a few figures in front of you before you place anything. First, the strike price and expiration date of each leg. Second, the price of each option, which your broker shows as a bid and an ask. The bid is what buyers offer. The ask is what sellers want. You pay near the ask on the far option and receive near the bid on the near one. That gap is a real cost.

If you have never priced a contract, here is a small surprise. Each standard option contract covers 100 shares, so a quote of 2.00 dollars means 200 dollars for one contract. Add your broker's commission per contract and any exchange fees. Then look at your margin requirement, which is the cash your broker holds back. For a long calendar, many brokers ask only that you pay the debit. The requirement is set by your broker under Regulation T and exchange rules, so ask yours.

A few limits are set by law and change from year to year. For example, the pattern day trading rule asks for a minimum account balance of the current figure, which the official source publishes each year if you open and close positions within one day often enough. Read the Options Clearing Corporation booklet, Characteristics and Risks of Standardized Options, which brokers must give to options customers. FINRA also publishes plain guidance on options for retail investors at finra.org. Your own broker's statement shows what you actually paid.

A worked example

Let me tell you about a woman named Ruth. She has watched a company called Acme for a year. Acme trades at 50 dollars. She expects it to stay quiet for the next month.

Ruth sells one call with a strike of 50 dollars that expires in 30 days. She receives 1.50 dollars per share. She buys one call with the same 50 dollar strike that expires in 90 days. She pays 3.00 dollars per share.

Her net debit is 3.00 minus 1.50, which is 1.50 dollars per share. One contract covers 100 shares, so 1.50 times 100 equals 150 dollars. Her broker charges 0.65 dollars per contract per leg. Two legs times 0.65 is 1.30 dollars to open. So she is out 150 plus 1.30, or 151.30 dollars in all.

Thirty days pass. Acme sits at 50 dollars. The call she sold is now worth about 0.05 dollars. The call she bought has 60 days left and is worth 2.40 dollars. The spread is worth 2.40 minus 0.05, or 2.35 dollars per share. That is 2.35 times 100, or 235 dollars. Closing costs another 1.30 dollars in commissions. So she receives 235 minus 1.30, or 233.70 dollars. Her total outlay was 151.30 dollars. Her gain is 233.70 minus 151.30, which is 82.40 dollars.

Now suppose Acme jumps to 60 dollars instead. Both calls are deep in the money, and they trade close together. Say the far call is worth 10.40 and the near call is worth 10.10. The spread is worth 0.30 dollars per share, or 30 dollars. After 1.30 dollars to close, Ruth receives 28.70 dollars. Her loss is 151.30 minus 28.70, which is 122.60 dollars. Her figures are her own, made up to show the math, not a forecast.

Where it goes wrong

A calendar spread has a gentle face, and that fools people. I have seen plenty of folks think capped risk means no risk. It does not. You can lose the whole debit, and fees come on top. Hard to forget that.

If you are hoping for calm, a big move is the first trouble. When the stock leaps or drops well past the strike, the spread shrinks. A drop in implied volatility is the second. If the market calms down after you buy, the far option can lose value even when the stock sits still. Early assignment is the third. A call you sold can be exercised by its buyer before expiration, especially near a dividend date. Your broker will tell you what happens then, and it can be costly and confusing.

You have probably noticed how small costs pile up. Wide bid and ask gaps on thinly traded options eat into a thin gain. Commissions apply to every leg, both going in and coming out. Taxes matter too. Gains and losses on options follow rules set by the Internal Revenue Service, described in Publication 550, Investment Income and Expenses. Holding periods and how legs are treated can change your tax bill, so read that publication or ask a tax professional.

I have felt the pull of a tidy picture myself. A calendar looks clean on paper. Real prices are messier than the picture in your head.

Questions to answer before you leave this page

Can you say in your own words why the near option loses value faster than the far one? Do you know the most the spread itself can lose, and could you lose that amount without losing sleep? Have you looked at the bid and ask on both legs, and added up what you would pay in commissions to open and close? Do you know what your broker does if the option you sold is assigned early? Have you read the Options Clearing Corporation booklet, Characteristics and Risks of Standardized Options? And do you know which tax rules apply, according to IRS Publication 550, before you place a single trade?