Calendar and Diagonal Spreads

Option selling is a niche that attracts many retail and professional traders because it’s possible to profit from the passage of time. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time. But these spreads are unique in many ways. In order to be successful with them, it is important to understand their subtle qualities.Calendar Spreads:

Definition: A calendar spread, sometimes called a time spread or a horizontal spread, is an option strategy that involves buying one option and selling another option with the same strike price but with a different expiration date.At-expiration diagrams do a calendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value.

To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks. This is true of the variants of the calendar—double calendars, diagonals, and double diagonals—as well. This chapter will show how to analyze strategies that involve options with different expirations and discuss how and when to use them.

Buying the Calendar:The calendar spread and all its variations are commonly associated with income-generating spreads. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying a longer-term at-the-money option and selling a shorter-term at-themoney (ATM) option. The options must be either both calls or both puts.

Because this transaction results in a net debit—the longer-term option being purchased has a higher premium than the shorter-term option being sold—this is referred to as buying the calendar.The main intent of buying a calendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at a faster rate than the longer-term ATM option, the net theta is positive.

As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorterterm option expires. At this strike price, the long option has its highest value,while the short option expires without the trader’s getting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option.For example, a trader, Richard, watches Bed Bath & Beyond Inc.

(BBBY) on a regular basis. Richard believes that Bed Bath & Beyond will trade in a range around $57.50 a share (where it is trading now) over the next month. Richard buys the JanuaryFebruary 57.50 call calendar for 0.80.
Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade:Sell 1 Bed Bath & Beyond January 57.50 call at 1.30 Buy 1 Bed Bath & Beyond February 57.50 call at 2.10 Net debit 0.80 Richard’s best-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value.

If Richard created an at-expiration P&(L) diagram for his position, he’d have trouble because of the staggered expiration months. A general representation would look something like Exhibit 11.1.The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call.The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread.

If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value,even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be a loss.If Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be a negative-100-delta option, imitating short stock.

If Bed Bath & Beyond is trading high enough, the February 57.50 call will become a positive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-themoney option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17.

Therefore, Richard would essentially have a short stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call.The maximum loss to the upside is about 0.63 (0.80 2 0.17).The maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.