Timing Events with the Calendar Spread

BY WILLIAM MCLEAN

©2003 Reprinted with permission of Active Trader magazine (www.activetradermag.com)

News events can move markets, but not always as soon as people think. The calendar spread offers one way to capitalize on aspects of time, market direction and volatility.

Calendar (or “time”) spreads offer opportunities to capture profits when expectations over an upcoming event can cause short-term options to become overvalued relative to longer-term options. The calendar spreader takes advantage of this by selling the mispriced near-term option and buying the more properly-valued longer-term option.

A calendar spread consists of a short call option in one month and a long call option in a later month, both with the same strike price. Because the longerdated option necessarily costs more than the shorter-dated call, a calendar spread always requires a cash outlay, which means calendar spreads are “debit” spreads.

Calendar spreads can also be created using puts and, interestingly enough, the profit and loss profile for the put type is nearly identical to the call type. The following discussion focuses on a hypothetical call calendar spread — the ACTM Oct./Nov. 50 call calendar spread. We will follow the profit and loss of each component as the stock moves through the options’ strike prices.

The option position/underlying stock relationship Before putting on an option position, you should understand how the position will perform as the stock moves. This knowledge is crucial for implementing protective hedges. When viewed from this perspective, the goal of the calendar spread is always for the stock to go to the strike price and then sit at that price. The easiest way to understand this relationship is to look at each option of the position individually. Table 1 (above) shows how the value of the October 50 and November 50 call options change with the stock at different levels. The table also shows the value of the Oct./Nov. 50 calendar spread.

Assume ACTM stock is currently trading at $50, the October 50 calls are trading at $4.60 and the November 50 calls are trading at $6.40. There are 30 days until October expiration and 58 days until November expiration. Today, you buy 10 of the November 50 calls for $6.40 and sell 10 of the October 50 calls for $4.60, establishing the call calendar spread for a debit of $1.80 (i.e., you pay $1,800).

To determine the position’s profit potential, view the value of the spread at the short-term option’s expiration (see Table 2, opposite page). At October expiration, if ACTM trades to $0, neither call will have much value and your loss will be very close to $1,800. Similarly, if the stock rallies to $100 by October expiration, the spread also becomes nearly worthless. Your short call has lost $50 while your long call has made just a bit more than $50 ($50 in parity value and a small amount of premium attributed to time value).

Table 2 shows the calendar spread reaches its maximum value at the near-month expiration when the underlying stock is trading at the strike price — in this case, $50. At the October expiration the spread widens to $4.45, resulting in a profit of $2.65 ($4.45 - $1.80), or 147 percent. At this point, you could simply sell the long call to close the trade, or stay long this now very inexpensive option.

Trade bias and other nuances

It is possible to take a bearish, bullish or neutral calendar spread position. For example, if you’re bullish on the stock you can establish a calendar spread using a strike price above the current stock price. The calendar spread will benefit from the rise in the stock price up to the strike. However, other factors besides stock price can influence the price of the calendar spread.

This is where things get interesting. Time is an obvious factor in the price of a calendar spread, as the near-term option loses its value at a more rapid rate than the longer-term option. That’s beneficial for the calendar spreader: You are short the faster-decaying option. Tables 1 and 2 illustrate if the stock stays at $50, the near-term option will lose all of its value as the longer-term option will fall in price from $6.40 to $4.45, dropping only $1.95 in value, compared to the $4.60 loss for the
shorter-term option.

A less obvious factor affecting a calendar spread is fear, which drives the price of the spread by affecting what people are willing to pay for the insurance the options provide. The fear level reflects the uncertainty about where the stock price is going. If people are confident about the direction of the stock, their fear diminishes. Increased fear helps the calendar spreader because the longer-term option is more sensitive to these types of changes (which are, technically, changes in implied
volatility).

Another way to think about this is the more uncertainty there is, or the longer it has to work, the farther away from the current price the stock may travel. Rises in uncertainty levels, or fear, help the spreader by raising the price of the long options faster than the price of the short options.

Timing events

Sometimes market participants are simply wrong in assessing the time between certain events — earnings announcements, court rulings, FDA approvals, filing dates and so on — and the price action that results.

The informed calendar spreader can make money by realizing not everyone understands the distinction between the announcement of an event and the unfolding of the price action that stems from that event. Traders will often bid up the price of near-term options to protect themselves against adverse moves they perceive will happen as a result of an announcement. However, what ends up happening is the options expire before the real price action occurs.

Understanding this, the astute calendar spreader in effect lets such market participants finance his or her own option purchase by selling the inflated (shorter-term) option premiums in order to buy the cheaper (longer-term), more relevant options.

The variables

The contradictory nature of this spread can lead to a couple of toss-up scenarios that affect the probability of a given trade. The stock may sit at the strike price (you win), but fear levels collapse enough (you lose) to offset the winnings. Another situation might be the stock moves (you lose) but fear levels increase enough (you
win) that you end up profitable. As always, there are no sure things, only reasonable propositions. The important point to realize is the calendar spreader
is playing direction, time and implied volatility.

Here are a couple tricks of the trade to find calendar spread candidates: The first is to look at the net difference between the implied volatility levels of
the at-the-money options between expiration months. If a near-month, at-themoney implied volatility level is well above the next couple of months’ at-themoney
implied volatility levels, see if you can come up with a logical explanation. Look at the corporate calendar and figure out what all the fear is about. If it can’t be justified, you may have a calendar spread candidate.

Another quick way is to compare the ratio of the premium over parity (the part of the option price attributed to time value) in the near-month option to that of the spread price. For example, using the prices from the previous example: The premium over parity in the October 50 calls with stock at $50 is $4.60, the spread price is $1.80, and the ratio of the two is $4.60/$1.80 = 2.55.

As the price of the near-month options increase relative to the further-out month options, this ratio will increase (i.e., the higher the ratio, the better the potential candidate). What is a “good” ratio? This changes through time, but recently opportunities have occurred when ratios are above 3. This simple tool lets you compare lots of stocks fairly quickly to find a couple of good candidates.