Neutral Calendar Spread Explained

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Neutral Calendar Spread

The neutral calendar spread strategy involves buying long term calls and simultaneously writing an equal number of near-month at-the-money or slightly out-of-the-money calls of the same underlying security with the same strike price.

Neutral Calendar Spread Construction
Sell 1 Near-Term ATM Call
Buy 1 Long-Term ATM Call

The options trader applying this strategy is neutral towards the underlying for the short term and is selling the near month calls to profit from their rapid time decay.

Limited Profit Potential

The maximum possible profit for the neutral calendar spread is limited to the premiums collected from the sale of the near month options minus any time decay of the longer term options. This happens if the underlying stock price remains unchanged on expiration of the near month options.

Limited Downside Risk

The maximum possible loss for the neutral calendar spread is limited to the initial debit taken to put on the spread. It occurs when the stock price goes down and stays down until expiration of the longer term options.

Example

In June, an options trader believes that XYZ stock trading at $40 is going to trade sideways for the next few months. He enters a neutral calendar spread by buying a OCT 40 call for $400 and writing a JUL 40 call for $200. The net investment required to put on the spread is a debit of $200.

As expected, the stock price of XYZ closes at $40 on expiration date of the near term call and the JUL 40 call expires worthless. The long term call lost some value due to time decay but is still worth $350. Selling this call nets him a $150 profit after taking into account the initial debit of $200.

If the price of XYZ had instead declined to $37 and stayed at $37 until October, both options expire worthless. The trader will also be unable to write additional calls since they are too far out-of-the-money to bring in significant premiums. Hence, he will lose his entire investment of $200, which is also his maximum possible loss.

Follow-up Action on Near-Term Expiration

Like all calendar strategies, it is necessary to decide on which follow-up action to take when the near-term options expire. This decision depends heavily on the revised outlook of the underlying stock at that time.

Should the neutral calendar spread trader thinks that the underlying volatility will remain low, then he may wish to enter another calendar spread by writing another near term call.

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If he thinks that the volatility is likely to increase significantly, he may wish to hold on to the long term call to profit from any large upward price movement that may occur.

However, if the options trader is unsure of what to expect of the underlying, it may be best to take profit (or loss) and move on to evaluate other trading possibilities.

Note: While we have covered the use of this strategy with reference to stock options, the neutral calendar spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the neutral calendar spread in that they are also low volatility strategies that have limited profit potential and limited risk.

ETF Options Strategies: Neutral Calendar Spread Explained

Exchange-traded funds (“ETFs”) provide an easy way for investors to gain access to nearly any country or asset class. In addition to providing diversified exposure in a single U.S.-traded security, ETFs are equities themselves that may have options available to trade. These options open up the door for investors to create additional highly targeted strategies [see also ETF Call And Put Options Explained].

In this article, we’ll look at the neutral calendar spread strategy and explore how ETF investors can use it to capitalize on sideways trading.

What Is a Neutral Calendar Spread Strategy?

Suppose an investor owns a commodity ETF that he or she uses to diversify an otherwise equity-heavy portfolio. Since the ETF is being used as a hedge, the investor may not be particularly bullish on the commodity ETF’s prospects. In this case, the investor could employ a neutral calendar spread in order to generate income from this sideways trading.

The investor would simply sell one near-term at-the-money call and buy one long-term at-the-money call option to create the neutral calendar spread. The resulting position takes advantage of the short-term option’s time decay, with the maximum losses limited to the debit taken to enter into the position, making it a relatively safe and predictable strategy [see Covered Call ETF Options Strategy Explained].

The resulting option diagram look like this:

Who Is the Neutral Calendar Spread Strategy Right For?

The neutral calendar spread strategy is perfect for investors that have a neutral outlook on a given ETF, which can occur for a variety of different reasons. In the example above, the investor was holding the ETF as a hedge and may not be expecting it to rise or fall in the near-term. But, other examples could include any other ETF that lacks a catalyst or is trading sideways [see also How To Hedge With ETFs].

The strategy works best in neutral markets, where the underlying stock price remains unchanged upon expiration of the near-term call option. The ideal market for this strategy would have very little in the way of near-term fundamental catalysts and would be exhibiting sideways trading patterns when using technical analysis (e.g. within a defined price channel).

What Are the Risks/Rewards?

The neutral calendar spread strategy has a very well defined risk to reward profile. Profit potential is limited to the premiums collected from the sale of the near-term call option minus any time decay of the long-term call option. Meanwhile, downside risks are limited to the initial debit taken to enter into the position, which goes into effect when the stock price declines [see also How To Take Profits And Cut Losses When Trading ETFs].

The maximum profit and loss scenarios are:

  • Maximum Profit occurs when the underlying stock remains unchanged upon expiration of the near-term month option.
  • Maximum Loss occurs when the underlying stock falls and stays lower until expiration of the long-term month option.

How to Use a Neutral Calendar Spread Strategy

Suppose that an investor owns 100 shares of the SPDR Gold Trust ETF (GLD, A-) and believes that it will trade sideways over the coming three months. So, he or she decides to use the neutral calendar spread strategy and sell/write one near-term at-the-money JUN 140 call for $4.83 and buy one long-term at-the-money AUG 140 call for $6.05 for a net debit of $122 to enter the position.

There are three basic scenarios that could then play out:

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