This week, we explore the dynamics of the 1-to-1 calendar spread. Most of the time, the investor buys what is called a "long calendar spread" in which he or she buys the longer-term call (or put) and writes the shorter-term call (or put) at the same strike price. These long calendar spreads make money as time passes and as the stock ends up reasonably close to the strike price. You can use our template, Whatifi3.Xls, to get a clear picture of how a calendar spread is likely to behave. You can use another one of our templates, Spreadsearch2.Xls, to find calendar spreads that are attractively priced, according to our model.
The Long At-the-Money Calendar Spread
The Exchanges do not require a margin on a long 1-to-1 calendar spread. This is because the longer-dated purchased option covers the risk of the shorter-dated written one. If the strike price on a long calendar spread is at-the-money (or close-to-the-money), then the spread is "delta neutral, since both options have approximately "50 delta." Thus, for small movements in the stock close to the strike price, a change in the purchased option will offset the change written option. Because it is "delta neutral," a long at-the-money calendar spread can be a viable substitute for a short straddle (in which you simultaneously write an at-the-money call and an at-the-money put.) The calendar spread makes money with the passage of time because the option written loses premium at a faster rate than the one purchased.
One advantage of the calendar spread over the short straddle is that it requires relatively less capital to establish. While the short straddle requires margin equal to 20% of the underlying, the calendar spread requires only the net premium paid. Another advantage of the calendar spread over the short straddle is its limited risk. Whereas with the short straddle, your losses are potentially unlimited, with the calendar spread your maximum loss is basically the premium paid. If the two options end up far out-of-the-money at expiration, the investor loses only the entire net debit. If the two options end up deep in-the-money, the options' intrinsic values will offset each other, so the loss will be limited to the net time premium.
There is one other important difference between a long calendar spread and a short straddle. That is you actually make money if the implied volatilities of the long and the short option rise by equal proportions. This is because these implied volatility changes will cause the dollar amount of your long option to rise more than the dollar amount of your short option.
An Puts Calendar Spread Example
In Figure 1 on page 1, we have used our spreadsheet template Whatifi3.Xls to calculate the likely outcomes of a long calendar spread on Qualcomm. With the stock at $39.82, we have written the overpriced November $40 put at $1.90 and bought the underpriced January $40 put for $2.80. The net debit for the spread comes to $90 versus our model's estimated net debit of $133.
In Graph 1 on page 3, we show the P/L of the two legs (short short-dated put and long long-dated put) of this spread to the nearest expiration (11/18/06), and the net of these two positions. As the stock rises, the profits of the short-dated short put top out pretty quickly while the losses on the long-dated long put increase. As the stock falls, the losses on the short-dated short put rise more quickly than the gains on the long-dated long put.
In Graph 2 on page 4, we show the net of the two positions over three time periods: (1) the day the spread was created (10/17/2006); (2) halfway to the nearest expiration date (10/31/06); and, (3) at the nearest expiration (11/18/06).
We can see from these two graphs that if Qualcomm ends up on at the November expiration the initial price of $39.82, the investor could expect a net profit of about $112. What has happened is that the shorter term written option has lost most of its value, while the longer-term purchased option retains a significant portion of its value. This scenario assumes that the underlying pricing (i.e. implied) volatility of the longer-term option has remained the same.
As the graphs show, the breakeven points for this strategy can be a fair distance from the current stock price considering the short time frame. At expiration of the November put, the common would have to fall by rise by about 7.0% or rise by about 9.5% before the investor would suffer a loss.
Using Other Strikes
What if you use higher or lower strike prices in a long calendar spread rather than close-to-the-money strike prices? The answer is that it doesn't matter whether you use calls or puts, if you use the higher strike prices, then the spread will be bullish. If you use the lower strike prices, the spread will be basically bearish.
With the higher strike prices, the net delta of the long calendar spread will be positive. With calls, the longer-dated long call will have a higher delta than the shorter-dated short call. With puts, the shorter-dated short put will have a higher delta than the longer-dated long put. Also, with these spreads (calls or puts), you get your maximum profit if the stock ends up at the strike price.
With the lower strike prices, the net delta will be negative. With calls, the shorter-term short call will have a higher negative delta than the longer-term long call's positive delta. With puts, the longer-term long put will have a higher negative delta than the shorter-term short put's positive delta. With these lower strike calendar spreads, you get your maximum profit if the stock ends up at this lower strike price.
Finding Calendar Spreads with Spreadsearch2.Xls
It is quite easy to find calendar spreads that can suit your needs with our new template, Spreadsearch2.Xls. (See our Quick Study Guide is Options Reports for instructions on how to use this template.") In Figure 2 on page 4, we show a search for favorably priced long calendar spreads. After searching for long calendar spreads that are two expirations apart, we have narrowed our selection down by selecting strike prices that are no more than 3% out-of-the-money and no more than 3% in-the-money.
We have also selected only spreads in which the option purchased is underpriced and the option written is overpriced. Finally we limited our search to spreads in which the written options expire in November and in which the underlying common stock has a neutral rank of 3.