Calendar Spread options (CSO) are options on the spread between two futures contract months, rather than a single underlying contract month. Unlike vanilla options, in which the option gives the holder the right to enter into a long or short futures position,
Calendar Spread options exercise into two separate futures positions ‒ one long and one short.
For example, a Corn option derives it price and potentially exercises into a corn futures contract. Whereas, a Corn Calendar Spread option derives its price from the price differential between two Corn futures contract months. Agricultural Calendar Spread options are offered on a wide array of future spreads for Corn, Soybeans, Soybean Meal, Soybean Oil, and Wheat contracts.
The consecutive spread, which is defined as the two front contracts, is a popular CSO and spread. One example of a consecutive spread would be the May-July spread at the beginning of April. May is the front month contract with July being the next Corn futures contract listed.
Calendar Spread options provide a leveraged means of hedging against or capitalizing on a change in the shape of the futures term structure. A call option can be exercised into a long futures position that is closest to expiration and a short futures position in a more distant month. The put option can be exercised into a short futures position that is closest to expiration and a long futures position in a more distant month. The strike price is the price differential between the long and short futures positions or the spread.
A corn trader is expecting very good growing conditions this spring and is bullish on the July-December spread, expecting July futures prices to trend much higher relative to December futures prices. On March 1, the July-December spread is trading at a differential of $0.20, with July at $4.47 and December at $4.27. The trader believes the July-December spread will settle higher than $1 when it expires in July. The trader purchases a CSO call on the July-December spread at a strike price of $0.30 at a cost of $0.05.
In order to break even, the July-December spread must reach at least $0.35 upon expiration. Purchasing a call limits the trader’s downside risk versus going long the futures spread. The maximum loss on the CSO is the premium paid, $0.05, where the maximum loss on a futures position can be much greater. At July option expiration, the July-December spread settles at $0.90 with July at $5.40 and December at $4.50. The trader’s bullish sentiment was correct, and their CSO call settled in-the-money by $0.60, netting a profit of $0.55.
If a trader had the opposite view of the July-December spread and thought it was going to decrease in price, purchasing a put option could be an effective way to express that view. Upon expiration, a put gives a trader the ability to be short the front contract, July and long the differed contract, December, at the strike price of the option.
Vanilla options on CME Group Agricultural futures have an American-style expiration. Calendar Spread options have a European-style expiration, meaning the option contracts cannot be exercised early.
CSOs expire on the same date as standard Grain and Oilseed options. For example, a July-December Corn CSO would expire on the same date as a standard July Corn option.
Grain price spreads can experience high volatility due to various fundamental factors including weather, economic growth, and unanticipated supply and demand. Unpredictable changes from any of these factors can have an impact on forward curve prices and the correlation between the calendar months.
Calendar Spread options provide a leveraged means of hedging against or capitalizing on a change in the shape of the futures term structure.
For additional information please visit cmegroup.com/cso.