The Anatomy of a Calendar Spread

Calendar spreads can offer traders a way to express views on volatility and time—not just market direction. In this episode, Jeff Praissman and Dmitry Pargamanik of Market Chameleon break down the anatomy of a calendar spread, covering implied volatility, vega, event risk, assignment considerations, and what separates a well-structured trade from a risky one.

Summary – IBKR Podcasts Ep. 412

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi, everyone. This is Jeff Praissman with Interactive Brokers Podcast. It’s my pleasure to welcome back to the IBKR Podcast Studio, Dmitry Pargamanik from Market Chameleon. Hey, Dmitry, how are you? 

Dmitry Pargamanik

Hey, Jeff. Thanks for having me. 

Jeff Praissman

I always love having you swing by the studio after you do your webinars. And for our listeners, Dmitry and Will from Market Chameleon do a morning show on YouTube every day. What is it? At 9:00 AM, Dmitry, that it starts? 

Dmitry Pargamanik

Yeah, we usually do look right at 9:00 AM before the market opens. 

Jeff Praissman

They’re also frequent contributors to the IBKR Campus through articles, webinars, and our monthly podcast as well. So, Dmitry, today we’re gonna kinda follow up on the webinar you just did on calendar spreads. And I wanna kinda kick it off with a question of, you know, why do calendar spreads offer a unique way for traders to, you know, express their market view beyond simply just being bullish or bearish? 

Dmitry Pargamanik

Yeah. And, you know, calendar spreads, you know, it’s an interesting strategy. Actually, we looked it up because one of the customers just asked us, “Well, how popular are calendar spreads?” And when you look at strategies, you know, multi-leg strategies, right now it’s the second most popular after vertical spreads, although vertical spreads are much more, you know, maybe like 10 times more popular than calendar spreads. 

And vertical spreads usually let you, you know, express a bullish or bearish view. In a calendar spread, you’re looking at two different expirations where you’re buying an option in one expiration, selling an option in a different expiration on the same strike. And that has a different type of risk profile and outlook because now you’re looking at a term structure where the implied volatility of two different expirations, you know, could be different. And by trading that strategy, you’re trying to take or capitalize on that difference in the premiums between two different expirations. 

Jeff Praissman

And, you know, Dmitry, we always seem to talk about implied volatility when you guys are on. And this is no different, right? So implied volatility is really actually a key component. I mean, it’s a key component of options in general, but definitely a key component of calendar spread trading. So how should investors think about volatility when they’re evaluating these strategies? 

Dmitry Pargamanik

Yeah. So when we look at a calendar spread, there are a couple things about calendar spreads. When we look at the vega risk of an option, the vega risk of a longer-term, longer-dated option is much higher than a shorter-term option because that option has more premium and it’s more sensitive to one implied volatility move. Okay? So it’s not exactly the same if, you know, you have two options, you know, one that expires in 10 days, and let’s say one expires in 100 days. Well, the vega risk with that 100-day option is much higher. So one volatility click, you know, in an option with 100 days to go might, let’s just say, increase or decrease by 20 cents, while the corresponding 10-day option could be a penny. So there’s an implied volatility difference, but there’s also a vega risk associated with each option that, you know, each trader has to understand because one volatility click move in a 100-day option can correspond to 10 vol clicks in the shorter-dated option, right? So it’s not, you know, one for one when each of them moves. 

So that’s an important piece to understand. Well, what does one vol click correspond to from a longer-dated option to a shorter-dated one? Because, you know, when you’re looking, for example, at some kind of a reversion, you know, if one vol click goes down by one and the other one goes down by five, that might not be enough, you know, to offset. So you have an implied volatility difference, but you also have a vega component that you need to factor in. 

Jeff Praissman

Yeah, and that’s a good point with the different expirations because so many standard, you know, spreads like verticals and straddles and strangles are all the same expiration. And that kind of, you know, leads me perfectly to my next question because, you know, so many traders just focus on, you know, stock price direction. But really, time is such an important factor when it comes to calendar spreads. You know, kind of dig a little bit more into that. 

Dmitry Pargamanik

Yeah. So with calendar spreads, you have two different components, you know, and you have two different expirations. And those expirations could cover different things as well. So a certain expiration can cover, let’s say, earnings, and another one doesn’t cover earnings, you know, or covers an event. One can cover a different type of event while the other one doesn’t. So the timing really matters when you put these spreads on, you know, unlike a vertical spread, which covers the exact same timeframe. They expire all at the same time in a vertical spread. With a calendar spread, well, you have this strategy, but the strategy really ceases to exist after that first expiration, right? So after the first expiration, what will happen is, well, your shorter-dated option, if it’s worthless, goes away. Now you have just that longer-dated option. If it’s in the money, well, that will get assigned unless you close out of it. So if you get assigned, well, then you’re left with a position where you have a stock position and an option position. So the time there really matters with options, how you put on that spread, and all the different factors that play into the time component. 

Jeff Praissman

And how can, you know, investors determine whether a calendar spread, you know, appears relatively expensive or cheap before entering the trade? ‘Cause they’re really dealing with, again, back to those two expirations. It’s a little hard to… 

Dmitry Pargamanik

Yeah. 

Jeff Praissman

…apples to apples. 

Dmitry Pargamanik

Yeah. That’s the issue with time spreads. Okay, now we have these two different expirations. They have different implied volatilities and different relationships relative to each other. So how do we know, you know, if it’s the combination of that spread on the low end or high end, right? So implied volatility alone doesn’t tell us. You know, an implied volatility benchmark alone won’t tell us because we need to know the relationship of buying one versus the other. So there you have to create a different benchmark where you measure, historically, that actual combination, that strategy. And then you could get, just like you would with implied volatility, a low-end, high-end, average, and median value for that strategy and then compare that to the market prices. So it involves creating a new type of benchmark that’s more specific to, you know, where the strikes are relative to the spot price and how much time is left to expiration in each of those components. Using those conditions, then you’d have to go in history, find those conditions, and see historically where that spread, you know, was valued. 

Jeff Praissman

Yeah. And how does that, you know, relationship between short-term and longer-term option pricing, how does it play into the success of a, you know, calendar spread? 

Dmitry Pargamanik

Yeah. So, you know, when we look at a… There are a few things in a calendar spread where you have a certain outlook. So I’ll go over a long calendar spread because a short calendar spread would just be the opposite of that outlook. So, a long calendar spread. Let’s say you have two calls on the same strike, you know, and you’re buying a longer-term option, selling a shorter-term option. Well, one piece of it is you do have some directional bias because the sweet spot for that spread is that the stock floats right to the strike price at expiration, the first expiration, right? So if you pick higher strikes, you want the stock to go up to that strike. If you pick lower strikes, you want the stock to go lower to hit that strike. 

The reason behind it is, well, if you’re short the shorter-dated option and the stock expires right at the money, let’s just say, you know, where you don’t get assigned or exercised, well, that premium that you sold it for, you keep, right? It goes worthless. So you sold an option that’s worthless. It goes away, so that’s a great scenario for you. And at the same time, the option that you’re long, well, that’s exactly at the money. And when an option’s exactly at the money, that’s where the time premium is the highest because it’s all time premium, right? You know, there’s no intrinsic value. It’s all time premium, and it’s right at the spot where it’s the most time premium, right? 

So that’s one outlook and bias. But the other one is that if you’re long that option, you want implied volatility to go up in the option you’re long. So since you’re long the longer-dated option, your outlook is you’re hoping that the implied volatility on that option increases, you know, over time or, you know, from the time you bought it. 

So you have those two types of factors that come into play, or outlook, when you’re executing a calendar spread. 

Jeff Praissman

And I’d imagine, again, that there are potentially different risks traders are taking when they’re doing calendar spreads versus, you know, spreads or combinations in the same expiration. You know, what are some of the biggest ones that they may underestimate when they’re implementing calendar spread strategies? 

Dmitry Pargamanik

Yeah. I think two main risks come to mind. One is that you always do have an assignment risk on the one you’re short, so you should be aware of that. So if the stock crosses and they’re both in the money, well, you could get assigned on one of your shorts and you could end up having stock, you know, and an option. On the flip side, you may want to exercise one of your options for a dividend or interest. When options are in an early exercise situation, it goes both ways. You have to always evaluate, am I better off holding onto the option or exercising it, you know, if you’re looking at a dividend or carry? But the other factor is what we talked about, and that’s your vega risk. And people underestimate where they look only at the implied volatility between the two, but not the vega risk of the two, and that’s important. 

What is the relationship? What does one implied volatility change in the longer term correspond to? How many implied volatility changes in the shorter term do those two equal? Because you could have like a 10-to-1, 20-to-1 ratio, you know, where one click in the longer-term option translates to, just to break even, a 20-click decline, you know, in the shorter term that you’re short. So those two kind of come to mind. 

Jeff Praissman

And, you know, just to kind of clarify for our listeners too, like you had mentioned, if both legs are in the money, you may get assigned on one. You know, the difference, obviously, with it being a calendar spread is even if you’re long one and it’s a few expirations out, it may not make sense to exercise it. Whereas if it was like a vertical spread, if there are two legs to that vertical spread that are in the money in the same expiration, chances are if you were assigned one, you probably would be wanting to exercise the other one anyway, or close to it. Not a 100% guarantee, but more likely versus your long one that’s two months out and it’s not really, you know, worth exercising, whereas the one that you get assigned, all of a sudden… 

Dmitry Pargamanik

Right. I mean, right. So you’ll have a different position, basically, from where you started out with. Yeah. 

Jeff Praissman

…or short, or long stock. 

Jeff Praissman

So, Dmitry, what separates a high-quality calendar spread setup from one that may look appealing on the surface, but carries some unfavorable risk-reward characteristics underneath? 

Dmitry Pargamanik

I think there’s probably no one right answer to that. You know, sometimes people do calendar spreads for different reasons that fit their portfolio or a certain outlook. You certainly want to be aware of the bid-ask spreads in them because they could be wide, and when you’re getting an execution, you wanna get a good-quality execution. Or you may end up trading on a wide spread where the entry or exit were so unfavorable that it would be very difficult to make that a good spread. I think it really just depends on your outlook and what you’re trying to do. 

I think a lot of calendar spreads that we see trading in the market currently actually turn out to be rolls, where an existing position is coming closer to expiration and that position is rolled into a longer-term option, but in the form of a calendar spread. In actuality, it turns out to be just a roll where you had a position in one option, you went to a different option, and closed out the option you had. But a calendar spread would be something different where you want to hold both positions. 

Jeff Praissman

Right. Opening both positions versus closing one and rolling it to another. 

Dmitry Pargamanik

Yeah, exactly. So sometimes when we see a calendar spread, it actually turns out to be a roll. But like you said, a calendar spread is when you wanna be open in both positions. 

Jeff Praissman

Yep. And why do calendar spreads tend to appeal to traders who believe the market may be overestimating or underestimating future volatility? 

Dmitry Pargamanik

Also a good question because the calendar spread allows you to take a certain outlook where you do believe, well, I think we’re in a low implied volatility regime. We might be here for a little while. You know, you might not think volatility’s gonna return tomorrow or in the summer months or, you know, not in the near-term horizon. So you may wanna do a longer-term contract, but finance some of that with a shorter-term option to offset some of the costs. So that would be one reason to do it as a calendar spread because you think, well, over time implied volatility will start going up, and in the short term it might stay lower, and then you do it that way. Or you could go in the opposite direction, where you think, well, we’re in a very high volatility regime. 

Jeff Praissman

Mm-hmm. 

Dmitry Pargamanik

And I think it’s gonna stay here for a little bit, but over the long term it’s not sustainable and it’s gonna start reverting back to normal, where you want to own, let’s say, the next 20 or 30 days of volatility. But you think beyond that it’s unnecessary because whatever is happening today is gonna eventually get repriced, then we’re gonna start going back to normal. So you do the opposite side of that, where you’re selling the longer term for the vega, but you’re hedging yourself and trying to take advantage of some of the gamma or the shorter-term swings. So that’s typically where you’re looking at the opposite sides of them. Again, that’s where you think, well, we’re maybe overestimated or underestimated in the longer term relative to the shorter term. 

Jeff Praissman

Final question, Dmitry. You actually kind of brought this up a little bit earlier with events. So how should investors think about earnings announcements or some other major news events, or even minor news events, when they’re evaluating calendar spread opportunities, right? ‘Cause you’re crossing different expirations. You’re kind of putting on different risks or, you know, you have some… 

Dmitry Pargamanik

Yeah, exactly. When it comes to options and event risk, looking at earnings, you have to look at the vega because the implied volatility in the shorter-term option that covers the event will be higher than the implied volatility of the longer term. But they’re not the same vega, right? So you’re not looking at the same vega risk. You’re just looking at implied volatility, which, in option terms, is the average daily volatility move. But that doesn’t factor in gap risk, right? So gap risk is something different. That’s where the Black-Scholes model doesn’t have a component for gapping. It just has a component for volatility, which it assumes doesn’t gap. It hits every price before it gets to a new price. So when we’re looking at earnings, I think then you have to really use a different type of model and thought process than just implied volatility alone. You’d have to look at, you know, your vega risk components, what you think the stock may move or gap overnight, and factor that into your strategy. There you have a real potential for a big catalyst repricing that happens really quickly overnight. And when we’re doing calendar spreads in that situation, that’s a much different calculation and modeling of the strategy. 

Jeff Praissman

Ah, Dmitry, this has been great, as always. Love when you come by the studio. And for our listeners, again, you can find Dmitry and Will McBride from Market Chameleon every Monday through Friday—every time the market’s open—on YouTube at 9:00 AM on their YouTube channel, and of course on our IBKR Campus, webinars, podcasts, and articles. 

Thanks again, Dmitry. 

Dmitry Pargamanik

Thanks, Jeff. Thanks for having me.