What are option spreads?
Options spreads are the basic building of many option trading strategies. A spread position is entered by buying and selling an equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. The three main classes of spreads are the horizontal spread, the vertical spread, and the diagonal spread.
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What is a calendar spread options strategy?
A calendar spread is an option or futures strategy established by simultaneously entering a long and short position on the same underlying asset but with different delivery dates. It is sometimes referred to as intra-market, time spread, inter-delivery, or horizontal spread.
In a typical calendar spread, one would buy a longer-term contract and go short a nearer-term option with the same strike price. If two different strike prices are used for each month, it is known as a diagonal spread.
How is it Constructed?
A calendar spread is an options strategy that is constructed by simultaneously buying and selling an option of the same type (calls or puts) and strike price, but different expirations. If the trader sets a near-term option and buys a longer-term option, the position is a long calendar spread. If the trader buys a near-term option and sells a long-term option, the position is a short calendar spread.
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Example and Payoff:
The market rallies downward. In this situation, the short-term call expires worthless, but the investor retains the premium. This limits her loss to Rs 33.75, which is lower than Rs 70.50, the actual cost of the long-term call without the spread.
The profit/loss diagram of the calendar spread shows that when the stock price increases, this type of trade suffers. Significant movement in either direction in a short period may be costly because of the way the higher gamma (the rate of change, or sensitivity, to a price change in the underlying security for delta) affects short-term contracts
A long calendar spread is a neutral trading strategy though, in some instances, it can be a directional trading strategy. It is used when a trader expects a gradual or sideways movement in the short term and has more direction bias over the life of the linger-dated option.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.