So far, we have seen spreads that use the same expiry month for the two legs. When you diverge from this simple strategy and create a spread in the same underlying and with the same strike price, but with different expiries, then you create a calendar spread (or a horizontal spread).
This change in strategy brings into play the effect of time value decay as well as volatility sensitivity of options and it fundamentally alters the risk-return profile of your position.
Horizontal spreads offer an opportunity to make profits as the two legs of the spread have different time sensitivities (Theta) and volatility sensitivities (Vega). The time value premium of an option is the part of its value that depends on how far expiry is.
Think of it this way – if you had an ATM option that would expire today, would you pay a premium for that? Of course, not, because you can simply buy the underlying from the market at the same price without paying any premium. But what if expiry is 10 days away? Now if you are interested in the underlying, buying an ATM call gives you a way to lock its current price.
In other words, you are protected from any rise in price in the next 10 days. If the spot price of the underlying goes up, you can simply exercise your option and get the underlying at a lower price, and if the price goes down, you can buy the underlying from the market and let the option expire. In either case, you would never have to pay for the underlying more than today’s spot price. That is why investors pay a premium for that option.
Now, what if expiry is 3 months away? It is easy to see, that the longer this time period, the better it is for you. With 3 months at your disposal, you have a much longer period to benefit from price movements, which is why investors are willing to pay a higher premium for back month options. As an option approaches expiry, this time value component falls at an increasingly faster pace. In other words, the Theta of the option rises faster and faster as it nears expiry.
A key aspect of a horizontal spread, which is also referred to as a time spread, is that it does well under a neutral outcome. Too much of a change in the price of the underlying in either direction is not good for such a spread, as it not only complicates the risk-return profile of the spread, but can also lead to higher losses. Investors are usually hoping for some stability in the underlying so that they can profit from the differential in time value decays of the two legs.
Another thing that you should keep in mind when creating horizontal spreads is that changes in volatility can have a significant impact on the spread value. Just like there is a Theta differential between options with different expiry, there is also a Vega differential.
A back month option will always have a higher Vega. So if you are buying a back month option and selling a near month one, your spread will have a positive Vega, which means your position will benefit from a rise in volatility. The opposite will happen when you buy a near month option and sell a back month one.
Let’s consider an example to better understand how horizontal spreads work. The September 105 ATM call option of stock A is quoting at premium = $2, Theta = 4 and Vega = 10. At the same time, the December 105 ATM call of the same stock is quoting at premium = $4, Theta = 1, and Vega = 20.
To create a horizontal spread, you can sell the near month (September) call and buy the back month (December) one. The immediate impact of the trade will be a $200 debit in your account. This is also the maximum loss that you can make on the trade, as you can always let the options expire.
If they are in the money at expiry, the gains from one leg would offset the losses from the other and your net loss will be the difference in premiums. If they are out of the money, they are worthless, and your net loss will again be the difference in premiums.
The spread Theta will be 4-1 = 3 (as Theta will be negative for the buy leg and positive for the sell leg). The spread Vega will be 20-10 = 10 (as Vega will be positive for buy leg and negative for the sell leg). It’s clear from the position Greeks that you stand to make profit as time passes as the spread is gaining $3 a day at the current rate.
As long as the underlying price does not move significantly, the passage of time itself will make the position profitable, assuming volatility also remains in check. As the price of the underlying goes up or down, the potential profits that you can earn from the position fall and beyond a certain range, the position becomes loss making.
What if volatility (or implied volatility) does change when you are holding the spread. The positive Vega shows that any increase in volatility will improve the position. But don’t forget that a change in volatility also means a change in the stock price, in which case the profit may not materialize at all.
This, however, is not the case with implied volatility. If after you open such a horizontal spread, the implied volatility goes up, and you close the position before it comes back down, then the Vega would help you make a bigger profit.
A reverse calendar spread can be created by reversing the transactions that take place in a regular horizontal spread. In the previous example, you can execute this strategy by buying the near month call and selling the back month call. This will completely reverse the Greeks of the spread, but in this case, you would start with a net credit of $200 in your account.
This is your maximum possible profit and it can be achieved if a rapid up or down move in the underlying completely offsets the impact of time value decay of your spread and this move is accompanied by a decline in implied volatility. Such a move can take place when the underlying has hit a bottom and is about to see a turnaround.
Calendar spreads using ATM options can be constructed through puts in the same way as they would be constructed using calls. The premiums for ATM calls and puts are very similar and the strategy that you can execute using call based calendar spreads can be more or less replicated using put based calendar spreads.
You would typically have a neutral outlook in horizontal spreads, i.e. neither bearish nor bullish, and you would just be looking to profit from time value and volatility changes. This means that it doesn’t make a lot of difference whether you use puts or calls for this kind of spread.
Next Chapter: Diagonal Option Spread