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If I buy a call calendar spread, and the underlying increases, both options are in the money by the expiry of the short call.

So both options increase in value, but the short one increases less because it has more time decay.

So, if I bought the calendar at the money, and the underlying increases 10$, do I lose my entire initial premium that I paid to enter the spread? Or can I salvage some?

Example:

  • Underlying at 40
  • Sell the March 40 call for 1 usd
  • Buy the April 40 call at 1.50 usd.
  • Results: pay 0.50 usd.

By Mar expiry, assume underlying goes to 45.

So, if both the March and April calls both increased to 5 usd, then I lose the entire initial 0.50 usd.

  • Is this the most probable outcome?
  • Or Will March increase to 5, and April increase to 5.20 because April still has some time value?

In that case, I can roll out of the spread for a .20 (by buying back March at 5 and sell April at 5.20): the loss would be 0.50 - 0.20 = 0.30 USD instead of the whole 0.50.

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  • $\begingroup$ I'm not really used to Calendar Spreads terminology, and might not be the only one here. You might get more answers if you just make the question a bit more formal like: 2 calls $c_1$ and $c_2$, with same underlying $S$, and describe maturities $T_1$, $T_2$ and strikes $K_1$, $K_2$ and you position in each of them (are you long the short-term one or long-term one?). This would also benefit the site in general $\endgroup$ – SRKX Mar 2 '15 at 3:14
  • $\begingroup$ Ok, I edited it again to make it cleaner. Please avoid abbreviation and try to use available formatting options to make it easier to read for the community. $\endgroup$ – SRKX Mar 3 '15 at 1:06
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The price of the April option will be more than $5.00, correct.

How much more depends on the implied volatility ($\sigma$) of the option and the interest rates ($r$). The higher $\sigma$ and $r$ are, the higher the time value of money and the value of the April option.

I highly recommend playing around with this calculator to gain an intuitive understanding of BS options pricing. Another good idea is to create your own pricing scenarios in Excel and graph the results of each strategy.

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  • $\begingroup$ Does it have to be higher than 5 strictly speaking? I mean if \sigma is very very low, then the value of the option is roughly the discounted value of $(K-S)^+$ right? But I agree, in common situations (decent $\sigma$ and relatively low $r$) there will be enough extrinsic value for the long-dated option to have more value than the short-dated one. $\endgroup$ – SRKX Mar 3 '15 at 4:04

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