Calendar Spread vs Diagonal Spread

Options trading has gained significant traction among Indian market participants, offering traders a range of strategies to manage risk, express market views and potentially benefit from different market conditions. However, options can be complex, and understanding how each strategy works is essential before putting it into practice. Two strategies that often catch the attention of options traders are calendar spreads and diagonal spreads. While both involve options with different expiry dates, they differ in their strike prices, market outlook and potential risk-reward characteristics. So, how do calendar spreads and diagonal spreads work, and how do they differ? Get answers to these questions and more in this blog where we decode these trading strategies. 

What is a Calendar Spread?

A calendar spread, also known as a time spread, is an options trading strategy that involves buying and selling two options on the same underlying asset and usually at the same strike price, but with different expiry dates. Typically, a trader sells the option with the nearer expiry and buys the option with a later expiry. For example, if a trader expects Nifty 50 to remain around a particular level in the near term, they could sell a Nifty option expiring in one week and buy another Nifty option with the same strike price expiring in the following month. The strategy aims to benefit from the difference in time decay between the two options. Since the near-term option generally loses time value faster as expiry approaches, the trader may benefit if the underlying stays within the expected range and the sold option loses value faster than the longer-dated option. A calendar spread can be created using either call options or put options, depending on the trader's market view. While the strategy can help traders express a view on time and volatility, it is important to understand factors such as time decay (theta), implied volatility, expiry dates and the movement of the underlying asset before using it.

How to Use a Calendar Spread?

A calendar spread means selling a shorter-expiry option and buying a longer-expiry option at the same strike price. The strategy primarily seeks to benefit from the difference in time decay and changes in option value across the two expiry periods, rather than simply betting on whether the underlying will rise or fall. Traders can use a calendar spread when they have a view that the underlying asset may remain relatively stable or move within a certain range over the near term. The calendar spread strategy can be used as follows.

• Choose the underlying asset - Select the stock or index to create the calendar spread, such as NIFTY 50, BANK NIFTY or an individual stock.

• Select the option type - Decide whether to use call options or put options based on your market view. A calendar spread can be created with either type of option.

• Choose the strike price - Select a strike price around which you expect the underlying to trade near the shorter expiry. For example, if NIFTY is trading at 25,000 and traders expect it to remain around this level, they could consider the 25,000 strike.

• Select two different expiry dates - A calendar spread always involves options with different expiry dates. Typically, the trader sells an option with a nearer expiry and buys an option with a later expiry, using the same strike price.

• Place the two trades - For example, a trader could sell a 25,000 NIFTY Call expiring in one week and buy a 25,000 NIFTY Call expiring in the following month. This creates a long calendar spread.

• Understand the initial cost - Since the longer-dated option generally has more time value, it usually costs more than the shorter-dated option. Therefore, a standard calendar spread is generally entered for a net debit, meaning the trader pays the difference between the premium paid for the long option and the premium received from the short option.

• Have a suitable market view - Calendar spreads are generally considered when the trader expects the underlying to remain near the selected strike price in the short term, rather than making a sharp move away from it. The exact profit or loss, however, depends on the underlying's movement, time decay and changes in implied volatility.

• Monitor time decay - The short-term option tends to lose time value faster as its expiry approaches. If the underlying remains near the chosen strike, the trader may benefit from this faster decay in the short option while continuing to hold the longer-dated option.

• Monitor implied volatility - Changes in implied volatility (IV) can affect the value of both options. A calendar spread may be particularly sensitive to changes in IV because the two options have different expiry dates.

• Decide when to exit - A trader can close the spread before the short option expires, or manage the position by closing the short option and deciding what to do with the longer-dated option. The exit should depend on the trader's strategy, market view, risk limit and the spread's profit or loss.

What is a Diagonal Spread?

A diagonal spread is an options trading strategy that involves buying and selling two options on the same underlying asset but with different expiry dates and different strike prices. Typically, a trader buys a longer-term option and sells a shorter-term option, while choosing different strike prices for the two contracts. For example, a trader expecting a moderately bullish view on NIFTY 50 could buy a longer-expiry 25,000 Call and sell a shorter-expiry 25,200 Call. Since the options have both different expiry dates and different strike prices, the strategy is called a diagonal spread. A diagonal spread combines elements of a calendar spread and a vertical spread, allowing traders to take a more specific view on the underlying's direction while also considering the impact of time decay. Depending on whether calls or puts are used and how the strike prices are selected, a diagonal spread can be structured for bullish, bearish or neutral market views. Traders should consider factors such as option premiums, time decay (theta), implied volatility, strike prices, expiry dates and the movement of the underlying asset before entering the strategy.

How to Use a Diagonal Spread? 

A diagonal spread combines different strike prices and different expiry dates. The trader generally buys a longer-expiry option and sells a shorter-expiry option, using the difference in strikes to express a directional view and the difference in expiries to benefit from changes in time value. A diagonal spread can be useful when a trader has a directional view on the underlying asset but also wants to take advantage of differences in option expiry and time decay. The diagonal spread strategy can be used as follows.

• Choose the underlying asset - Select the stock or index to create the spread, such as NIFTY 50, BANK NIFTY or an eligible stock option.

• Decide your market view - First determine whether traders have a bullish or bearish view. The strike prices and option type can then be selected accordingly. For example, call-based diagonal spreads are commonly structured for a bullish-to-moderately bullish view, while put-based structures can be used for a bearish-to-moderately bearish view.

• Choose the option type - Decide whether to use call options or put options. The choice depends on the direction traders expect the underlying to take.

• Select two different expiry dates - A diagonal spread uses options with different expiry dates. Typically, the trader buys the longer-expiry option and sells the shorter-expiry option.

• Select two different strike prices - Unlike a calendar spread, a diagonal spread uses different strike prices for the two options. For example, a trader could buy a longer-expiry 25,000 Call and sell a shorter-expiry 25,200 Call.

• Check the option premiums - Before entering the trade, compare the premiums of both options. Depending on the strikes, expiry dates and market conditions, the strategy may be established for a net debit or, in some structures, a net credit.

• Enter the two legs together - Buy one option and sell the other option according to the planned structure. Since the two legs have different strikes and expiry dates, the position's overall behaviour depends on both the underlying's movement and changes in time value.

• Use it when you expect a controlled move - A diagonal spread can be considered when traders expect the underlying to move in a particular direction but not necessarily make a very large move. For example, a trader with a moderately bullish view may buy a longer-dated call at a lower strike and sell a nearer-dated call at a higher strike.

• Benefit from the short option's time decay - The shorter-expiry option generally loses time value faster as expiry approaches. If the underlying moves as expected and the short option declines in value, this can benefit the overall position.

• Monitor the longer-term option - The longer-expiry option retains more time value and remains in the position after the short option approaches expiry. The trader can then decide whether to close the entire spread, roll the short option to another expiry or continue managing the position, depending on the strategy.

• Track implied volatility - Changes in implied volatility (IV) can affect both legs of the spread. As the options have different expiry dates, a change in IV can affect their premiums differently.

• Set an exit plan - Before entering the trade, decide the maximum loss acceptable and the conditions under which you will exit. A diagonal spread should be monitored because a sharp move in the underlying, an unexpected change in IV or changes in the value of either option can affect its profitability.

What are the Differences Between a Calendar Spread and a Diagonal Spread?

Both calendar spreads and diagonal spreads involve options with different expiry dates, but they differ mainly in their strike prices and the type of market view they can express. The key differences are explained below.

What are the Limitations of Using a Calendar Spread and a Diagonal Spread?

The limitations of calendar spread and diagonal spread are part of understanding and using them effectively. These limitations include,

• Calendar Spread

• Limited profit potential as returns depend on the underlying staying near the chosen strike.

• Changes in implied volatility can affect the spread's value.

• A sharp move away from the strike can reduce potential gains.

• The short option needs to be monitored as expiry approaches.

• Brokerage and other trading costs can reduce returns.

• Diagonal Spread

• Different strikes and expiry dates can make the strategy harder to manage.

• A sharp move against the trader's view can cause losses.

• Changes in implied volatility can affect both option legs differently.

• Choosing unsuitable strike prices can affect the strategy's outcome.

• The short option may need to be closed, rolled or adjusted before expiry.

Conclusion

Calendar spreads and diagonal spreads can both help traders use differences in option expiry and time decay, but they suit different market views. A calendar spread uses the same strike price with different expiries, while a diagonal spread uses different strike prices and expiries, giving traders more directional flexibility. Before using either strategy, traders should understand the impact of price movement, time decay, implied volatility, premiums and expiry, and manage the position according to their risk tolerance and trading plan.

This article is an attempt to explain the two important option trading startegies simplifying them for traders. Let us know your thoughts on the topic or if you need further information and we will address them soon.

Till then, Happy Reading!

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