Calendar Spreads

When an option has several months remaining before expiration, time decay is relatively slow. As time goes by, the rate of time decay (the option's theta) increases. When the option has less than 30 days remaining, time decay goes into high gear. Calendar (time) spreads take advantage of this characteristic.

In a typical horizontal calendar spread, you sell an option and at the same time you buy another option of the same type (call or put) on the same underlying asset and at the same strike price, but with a further out expiration.

Example: Calendar Spread

Price of Underlying: 50.00
	Premium	Days Remaining	Implied Volatility
Sell -1 June 50 Call	1.96	30	32.6%
Buy 1 July .50 Call	2.53	58	29.4%
Net cost of spread -0.57

Here's how it works:

	The June 50 call will lose premium faster than the July 50 call, causing the spread to widen (the value of the spread will increase).
	The ideal situation would be for the underlying to be trading at 50 when the June 50 call expires. It would expire worthless while the July 50 call, with 28 days remaining now (instead of 58), would still have time premium. If the market continued to price the July 50 call at the same implied volatility (29.4%), it would have a premium of 1.72.

Price of Underlying 30 days later: 50.00
	Premium	Days Remaining	Implied Volatility
June 50 Call	0.00	0
July .50 Call	1.72	28	29.4%

So, the calendar spread which cost you 0.57 would now be worth 1.72, for a profit of 1.15. That's a 200% return in only 30 days. Of course, there would be commissions and bid/ask slippage, but you get the idea how this strategy works.

Other Considerations:

The market should be in a trading range, the narrower, the better. Any big moves up or down will hurt this position and may result in a loss.

The options you sell should be overvalued relative to the options you buy. This will help to stack the odds in your favor.

It helps if implied volatility is increasing. This will increase the time value premium of the options you purchase (which have more time remaining than the options you sell in a calendar spread).

	You will recall from the Option Basics section that the vega of an option indicates how much the price of an option will change for each percent change in volatility. Vega decreases as an option's expiration date approaches.
	In a calendar spread, the options you buy have more time remaining and hence a larger vega than the options you sell. Which means that an increase in implied volatility will cause the price of the options you bought to increase more than the options you sold. This helps your position.
	And of course, if you stay in the calendar spread until the options you sold expire, they will expire without any time value, whereas the options you bought will still have time value remaining.

When you find a candidate for a calendar spread, make sure you identify the profit zone, that is, the price range which the underlying has to stay within for this strategy to be profitable. Also, look at what would happen to your position if implied volatility changes, and so on. This will help you to make sure you get into the best trades (and avoid the bad ones).

Calendar Spreads

Example: Calendar Spread

Price of Underlying: 50.00

Here's how it works:

Price of Underlying 30 days later: 50.00

Other Considerations: