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A calendar spread is an options trading strategy that involves buying a longer-dated option and selling a
shorter-dated option on the same underlying asset. The goal of a calendar spread is to profit from the
time decay of the shorter-dated option.
The time decay of an option refers to the loss of its value over time.
This is because options are priced based on the expected volatility of the
underlying asset. As time passes, the uncertainty about the future volatility
of the asset decreases, and the value of the option decreases.
In a calendar spread, the trader is betting that the time decay of the shorter-dated option
will be greater than the time decay of the longer-dated option. This is because the shorter-dated
option has less time to appreciate in value.
If the trader is correct, they will profit from the difference in the time decay
of the two options. However, if the underlying asset moves significantly in either
direction, the trader could lose money.
Here is an example of a calendar spread trade:
Buy one lot of Reliance Aug 2023 2600 strike call option for ₹60.
Sell one lot of Reliance July 2023 2600 strike call option for ₹20.
The net debit for this trade is ₹40.
The trader is betting that the price of the underlying asset will stay close
to ₹2600 between July and August. If the price of the asset stays close to ₹2600,
the time decay of the July 2600-strike call option will be greater than the time
decay of the August 2600-strike call option. This will result in a profit for the trader.
However, if the price of the asset moves significantly in either direction, the trader could lose money.
If the price of the asset goes above ₹2600, the August 2600-strike call option will appreciate in value,
but the July2600-strike call option will expire worthless. This will result in a loss for the trader.
If the price of the asset goes below ₹2600, the July 2600-strike call option will appreciate in value,
but the August 2600-strike call option will expire worthless. This will also result in a loss for the trader.
Calendar spreads are a relatively low-risk options trading strategy. However, they also offer limited profit potential.
Calendar spreads are best suited for traders who are neutral or slightly bullish on the underlying asset and who are
looking to profit from the time decay of options.
Low risk : Calendar spreads are a relatively low-risk options trading strategy. The maximum loss is limited to the net debit of the trade.
Limited profit potential : Calendar spreads also offer limited profit potential. The maximum profit is limited to the difference between the strike prices of the two options.
Good for neutral or slightly bullish traders : Calendar spreads are a good strategy for traders who are neutral or slightly bullish on the underlying asset.
Can be used to reduce the cost of a long position : Calendar spreads can also be used to reduce the cost of a long position in an underlying asset.
Limited profit potential: As mentioned earlier, calendar spreads offer limited profit potential. Risk of loss if the underlying asset moves significantly: Calendar spreads are also subject to the risk of loss if the underlying asset moves significantly in either direction. Complex to manage: Calendar spreads can be complex to manage, especially if the underlying asset is volatile.