We shall learn about the calendar spread options strategy in today's article. This strategy can be used in the futures too. A calendar spread is created by entering the short and long positions having different expiry dates.
In a calendar spread, traders can buy the contract for the long term and sell the contract in the near term, having the same strike price.
The calendar spread is sometimes called inter-delivery, intra-market, horizontal, or time spreads.
How to enter the Calendar spread:
To enter the calendar spread, traders will have to sell an option contract, which can be either call or put with the near-term expiry date, and purchase the long-term contract simultaneously; this can also be either call or put. Both of these contracts are of the same underlying asset and have the same strike price.
Sell near-term contract (call or put)
But long-term contract (call or put)
When you reverse the position mentioned above, meaning buying a short-term contract and selling a long term, it is called a reverse calendar spread.
More about the Calendar spread:
The main reason for using this strategy is to profit from the time decay factor or increase implied volatility in any direction.
As the goal is to profit from the volatility, choose the most liquid strike price near the current stock price.
To use this strategy, traders must study the market sentiments and analyze the market forecast.
Understanding the calendar strategy with an example:
We shall take an example and see its different outcomes under different market circumstances.
Suppose a trader believes that the stock price of the underlying asset will remain steady for two months; after that, it may rise, or there will be high volatility.
The long-term call option contract will be costly as it has more expiration time, but traders can offset that by selling one short-term option contract.
Assuming the shares of ABC limited are currently trading at ₹89.05 in Jan. here, a trader can enter the calendar spread as below:
Sell the Feb 89 call for ₹0.97 premium (₹97 per contract)
Buy the March 89 calls for ₹2.22 premium (₹222 per contract)
The strategy can be more profitable if ABC's stock price remains unchanged until the Feb expiry date. It will help traders to keep the premium collected by selling the contract.
If the stock rises after the Feb expiry and within the March expiry, the second leg of the strategy will earn profit.
The general expected move is stock becoming more volatile for the short term, which will lead the short-term contract to expire worthless, and it still allows the trader to gain profit from the stock price rise until the expiry in March.
Additional notes on the calendar spread:
A trader would have bought only the long options by paying ₹222. By involving in this strategy, his cost to enter is reduced to only ₹125 (222-97).
This is called increasing the margin and reducing the associated risk.
Based on the contract type, the strategy can be used to make a profit in neutral, bullish, and bearish market scenarios.
Thus, we have seen how by choosing the different expiry dates of the options contract, traders can reduce the overall cost and risk while maximizing the profit.
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