Calendar spreads are a favorite of traders in low volatility environments/situations since you can possibly benefit both from market direction and an increase in premiums driven by an anticipated rise in volatility. And they are generally low cost spreads which makes it easy to participate or to scale in for better prices.
A basic calendar spread consists of both a short option and a long option at the same strike, but in different expiry dates. You’ll be short the option closest to expiration (because it decays fastest) and you’ll be long the further dated option. These trades are put on for a debit, which represents the most you can lose. Risk is defined. And as long as the price of the underlying does not stray too far away above or below your strikes, you’ll be able to sell this spread for a credit at some point, and most likely for more than you paid for it.
Here’s a typical P/L graph for a calendar spread:
Here’s how I play them:
I love them when I have a directional bias and have a target in mind, but am not too certain on the timing. I especially love them when I’m bearish because often times when a stock or index moves down, volatility will rise. Due to the long option which has more time to expiration that will be positively effected more by the increase in the volatility, the spread gets extra juice resulting in an additional increase in value.
Let’s say XYZ stock is currently trading at $80, but I think it has a real chance to sell off down to the $75 level. I could buy the 75-strike put calendar spread. This spread would consist of a short 75 put in the near month expiration (ideally 40-60 days to expiration) and long a 75 put in the back month expiration (at least 70-90 days out). As the days go along, if XYZ trades down to 75 as I predicted, I could then close the spread for a near certain gain. That’s what most people do.
I like to also offer myself a second scenario to profit: As long as the stock doesn’t trade meaningfully through 75 to lower prices, I’ll look to let the short option expire worthless (or at least cover it very cheaply) and then hold the longer dated long put a couple weeks longer to possibly gain from the limitless* profit potential of a naked long option. At this point, it doesn’t cost you any more to hold for larger gains. The debit you paid at trade initiation still remains the most you can lose in this trade.
So, in effect, you have two scenarios that can play out profitably for you: Stock can trade to your strike while the full position is intact, allowing you to close the entire trade for a profit. Or, stock can take it’s time, and if you’re still confident in your directional bias when the short option expires worthless, you can hold on to the long option for the potential of unlimited gains.