Understanding the calendar spread strategy

Key components of a calendar spread

To understand the mechanics of calendar spreads, traders should consider three key factors.

Time decay (Theta)

Options lose value as they approach expiration, a phenomenon known as time decay. Short-term options decay rapidly, especially as expiration nears, whereas long-term options retain more value, cushioning the impact of time decay.

Implied volatility (Vega)

Changes in implied volatility can significantly affect a calendar spread’s value. Increases in implied volatility benefit the long-term option more than it harms the short-term one, whilst a decrease in implied volatility can reduce the spread’s value, potentially diminishing profitability.

Strike price selection

The choice of strike price determines the strategy’s risk and reward profile. At-the-Money options maximises time decay benefits but can be more sensitive to volatility changes. Meanwhile Out-of-the-Money or In-the-Money options alters the risk-reward balance and may require specific market expectations.

Practical example using the futures market

Let’s consider a scenario in the crude oil futures market.

Crude oil futures are set to expire in one week, while another contract expires in one month. An OPEC meeting is scheduled for the following week, with potential for significant price moves. Let’s say the crude oil price is USD 80 per barrel, with implied volatility differing across expirations:

• 1-week futures option = 45% implied volatility.
• 1-month futures option = 35% implied volatility.

Strategy:

1. Sell: 1-week USD 80 call option on crude oil futures.
2. Buy: 1-month USD 80 call option on crude oil futures.

The 1-week option is richly priced due to elevated implied volatility ahead of the OPEC meeting, whilst the 1-month option provides a hedge and retains value even after the meeting, assuming volatility stabilises. The trader aims to capitalise on the elevated 1-week implied volatility levels, which are much higher than the normalised level of 1 month, while maintaining some protection against delta, gamma, and vega.

If crude oil remains near USD 80 after the OPEC meeting, the 1-week option expires worthless, while the 1-month option retains significant value. If implied volatility drops sharply post-meeting, the spread’s profitability may diminish but can still benefit from time decay on the short option. A significant move lower or higher would see both options out of the money, resulting in a loss of the premium spent.

Tools for evaluating calendar spreads

Modern trading platforms and tools can provide valuable insights to help you fine-tune your calendar spread strategies. For example, they can estimate implied volatility changes around specific events, analyse historical volatility trends for similar scenarios, and evaluate potential outcomes for different strike price and expiration combinations.

The term structure of volatility for a specific product is the market consensus estimate of future realised volatility for each given option expiration period. Variations in this term structure can imply moves in the underlying futures contract being priced in due to an upcoming event. The implied move or expected move on the day of the catalyst is called forward implied volatility. Whether this number is too high or too low is based on the trader’s expectations, possibly relying on past moves for similar catalysts.

Risks of calendar spreads

Like any trading strategy, calendar spreads come with risks, and it is important to understand them before using this approach for the first time. Managing these risks effectively requires careful planning and continuous monitoring.

One key risk is unexpected price moves. If the underlying asset experiences a large directional shift, the spread can be negatively affected. Changes in implied volatility also pose a challenge, as a significant drop in longer-term implied volatility can reduce the strategy’s overall value. Additionally, liquidity issues can arise, particularly with thinly traded options, where wider bid-ask spreads may lead to higher transaction costs.

In conclusion

Calendar spreads offer a versatile and strategic way to navigate markets, especially during periods of heightened uncertainty. By balancing the interplay of time decay, implied volatility, and event-driven dynamics, traders can position themselves to profit from market inefficiencies.