A Calendar Spread is an options trading strategy involving the simultaneous long position, or purchase (sale) of a near dated option (put or call) and the shorting, or sale (purchase) of a back dated option. However, there is no strict definition of how “far-dated” the back option can be thus not excluding the use of warrants in this strategy. This basic form is sometimes referred to as a horizontal spread. The option contracts used will be on the same strike. This refers to the traditional method of listing of options prices in the newspapers where expiry months would be listed side by side. Strike prices are therefore displayed horizontally on the same line.
A related term using this etymology is a vertical spread. This involves the purchase and shorting of options with different strike prices but with the same expiry month. To construct a position using different strikes AND different expiry months would be known as a diagonal spread.
Spread Valuation
Differences in terminology may arise in whether or not the strategy is referred to as a long calendar spread or a short spread. The rule of thumb is whether or not the position was initiated for a credit or a debit. As longer dated options tend to be more expensive, a long spread would therefore involve the shorting of the near dated option and the purchase of the longer dated option. This results in a net cash outlay or debit. It is what would be expected if the consumer was purchasing something. However, depending on the time to expiry of the far dated option (which may not be very long) and short term implied volatility, there may be times when this situation is reversed. This is most likely immediately before an earnings announcement where shorter dated option can be more expensive than their longer dated counter parts. Consider the Call options in the table below.
| Inputs | Near Dated Option | Far Dated Option |
|---|---|---|
| Underlying Price | 100 | 100 |
| Exercise Price | 100 | 100 |
| Days Until Expiration | 15 | 45 |
| Interest Rates | 1 | 1 |
| Dividend Yield | 0 | 0 |
| Volatility | 50 | 25 |
| Theoretical Price | $4.06 | $3.56 |
The short term implied volatility because of the earnings announcement is not expected to last thus causing a temporary higher near term price.
Some traders may simply refer to the purchase of the near term option as being a long spread. In light of this variation in terminology, clarification in specific instances is strongly advised as the Calendar Spread strategy can be achieved with multiple permutations.
Using the Calendar Spread in Merger Arbitrage
The most common uses for a calendar spread in merger arbitrage is to sell near dated call premium and whilst holding a long position in the back month. As the Deal Closing Probability (DCP) increases and the target stock moves towards the offer price, the front months will keep expiring and eventually the trader is left with the long back month position. Alternatively, the trader may construct a position using puts. By selling near dated puts, the merger arbitrage trader can offset the cost of the protection from a far dated put position held as a hedge against the long stock position. If the deal consummates as expected the trader gains on the stock and minimizes the insurance cost. If the deal breaks, the trader is protected. Although an immediate deal break could be costly as there are two potential losses and no time to collect any premium decay from the near term options.
For additional background on options we recommend Buying and Selling Volatility by Kevin Connolly as a great introductory text or Natenberg’s Option Volatility and Pricing: Advanced Trading Strategies and Techniques often considered the bible by many options market makers.
