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-the-
money (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
shorter-term 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 January–February 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:
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 .