The Hindu Business Line : When to use Calendar Spreads?

Option traders would know that a majority of options expire worthless. And almost always, it is the time value of money that gets blamed for its demise. But is there any way traders can benefit from time value? While most traders resort to selling options and pocket the premium received when option contracts near their expiries, writing options can put-off traders with a low-risk appetite given the high-risk baggage that comes with it.

So, if you have the wherewithal to provide sufficient margin money for selling options, but your lower-risk appetite is resisting you, here is one way to lap up the benefits of selling options at a reduced risk - use calendar spreads.

What is calendar spread?

A calendar spread entails selling options with a near-month expiry, against the purchase of options for the same underlying and at the same strike price in the far month. This strategy can be used when you have neutral outlook on the underlying asset (index or stock) in near term (i.e. till such time the current month contract expires) and have a moderately bullish or bearish view on the same underlying over the far month. For instance, if you are setting a calendar spread on Nifty, it will imply that you have a more or less neutral outlook on the index this month, but a fairly bullish or bearish outlook the next month.

Sample this. If you are short-term neutral and long-term bullish on say, Nifty, instead of simply buying a Nifty September call, you can consider setting a calendar spread on it. You can do this by selling current month Nifty 4300 call (trading at Rs 75), against the purchase of September Nifty 4300 call (trading at Rs 180). Alternately, if you are short-term neutral but long-term bearish on Nifty, you can sell a Nifty 4300 August month put (trading at Rs 50) and purchase a Nifty 4300 Sep month put option (trading at Rs 165). But, if you are anticipating a sideways move in the underlying before the expiration of the first contract, you may be better off using slightly out of the money strike price for the options.

So, while the first leg of this spread seeks to benefit from the fading time value of money (that would wipe away the option premium as it nears expiry) helping you pocket the premium received on selling it, the second leg of the spread will benefit from an expected move in the underlying after the first contract’s expiry. In essence, this spread not only helps you play the time value favourably, but also helps you lower the cost of buying the second option.

Risk-reward

Calendar spreads come with a limited risk and high reward potential — limited risk, because the sold option is backed by the long option in the far month; high reward, for if your outlook on the underlying turns true to the tee, the potential reward from the long option can be quite high. But on the downside, if the underlying makes an adverse move, the maximum risk that you will suffer will be limited to the net debit paid while setting the spread. So, if the underlying moves unfavourably before the expiry of the first option (the one that was sold), you will stand the risk of that option being exercised. But since this would be offset by the gains in the long option, the loss will be limited when compared with what you would have borne had you sold naked options. However, the success of this spread would to a great extent, depend on the correctness of your outlook on the underlying within the time period of the far month contract.

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