The calendar spread options strategy is very widely used and has its special kind of purpose. It is often used to balance out portfolios because with it, it is possible to target specific strike prices. Here you will get a calendar spread explained:
The beauty of the calendar spread trading strategy is that it can be used for almost every direction. For a neutral, bullish or bearish market outlook. With calendar spreads you try to target one specific strike which can be as far OTM or close to the market as you desire. This is also the reason why this strategy is so great to balance out portfolios.
- Sell 1 Call (at whatever strike you want to target)
- Buy 1 Call (at same strike), the expiration for this long Call has to be at a further away expiration date than the expiration date of the short option (ex. expiration 1 month later)
- Sell 1 Put (at whatever strike you want to target)
- Buy 1 Put (at same strike), the expiration for this long Put has to be at a further away expiration date than the expiration date of the short option (ex. expiration 1 month later)
Profit and Loss:
A calendar spread is a defined risk strategy with a limited upside as well (until expiration of the shorter term option. If that expires worthless you are left with a long call or put with unlimited upside and defined risk). The maximum profit of the original strategy is rarely hit perfectly because to reach max profit the underlying price has to be at one specific strike. It is very difficult to predict this specific price and therefore max profit isn’t reached too often. But this strategy still profits when the price is near the targeted strike or if implied volatility rises enough. Max loss occurs when the price is far enough away from the targeted strike. The main profit of this strategy comes from the different rate of time decay of the two options. The short option is nearer to expiration and therefore ‘gains’ (sold option loses) value faster than the long further away option loses value.
This strategy can profit quite a lot from a rise in volatility because the back month long option will gain in value when IV rises. Therefore, the calendar spread option strategy logically should be traded in times of rather low volatility (under IV rank 50).
Until the expiration of the first contract time decay or Theta works in favor of this strategy. This is because the sold front month option loses value faster than the further away long option. This is what the whole strategy is based on. But after the expiration of the short option a calendar spread will turn into a long call or put (depending on what you used) and a normal long option loses value from time decay. So Theta then turns negative.