How to use Calendar Spread Strategy

Calendar spread strategy involves simultaneous buying and selling of options (or futures) having the same contract specifications except the expiration dates. So if you buy (sell) a 6,000 call option expiring in November and simultaneously sell (buy) a 6,000 call option expiring in December then you are engaging in calendar spread strategy. It can also be done with put option. Calendar spreads in futures will involve simultaneously going long in futures and shorting futures with different expiration dates.

Long calendar spread

A long calendar spread will involve buying an option with a longer expiration and selling an option with a shorter expiration at the same strike price. For example selling Nifty 6,000 call option (CE) expiring on 29 November (Nov) which is trading around Rs 57 and buying 6000 CE expiring on 27 December (Dec) which is trading at around Rs 97 on October 5, 2012. The Nifty closed at 5,747 in that session. This will entail an investment of Rs 40, which is also the maximum loss if the strategy does not work out.

Now to understand the profit pattern from calendar spread we can consider different scenarios.

Scenario 1: If the Nifty index declines to 5,000, then the November call option will expire worthless. The premium on the long maturity option (6000 CE Dec) would have fallen considerably, maybe as low as Rs 2 or 3. Thus the investor loses his initial investment of Rs 40, at maximum.

Scenario 2: If the Nifty index rises sharply (assume it rises to 6,500) then the short maturity option will result in loss of Rs 500 (Rs 6,500-6,000) but this will be compensated by the profit made on the long dated option. So he/she will lose the initial investment.

Scenario 3: If the price is close to the strike price of the short-dated maturity option (assume 6,010) then the short-dated maturity option will cost the investor either a small amount or nothing at all (in our case it will be –Rs 10). However, the long-dated option will be quite valuable due to time value as one more month is left for expiration and thus significant profit will be made.

Technically, the long calendar spread loses if the underlying deviates too far from the strike price. Time decay or theta (change in option price due to change in time for the long calendar spread) is on the traders side as the spread increases with time, everything else remaining same. This trade is best when implied volatility is low.

Substituting the call options with put will result in similar outcome due to put call parity. A reverse of the above strategy can also be constructed by selling a long dated option and buying a short dated one.

The above calendar spread is neutral calendar spread as the strike price chosen is close to the spot price. When a higher strike price is chosen then it is called a bullish calendar spread and when a lower strike price is chosen then it is called a bearish calendar spread.

> shaurya.mishra@thehindu.co.in

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