The idea behind the calendar spread is to sell time, which is why calendar spreads are also known as time spreads. A calendar spread is constructed through two simultaneous trades:
1. the purchase of an option, and
2. the sale of another option with the same strike price, but an earlier expiration.
This combination creates a fairly neutral position that benefits from the accelerated time decay of the front-month option sold short. As an option gets closer to expiration, the rate at which time value decays accelerates. In other words, the near-term option loses time value much more quickly than the longer-dated ones.
The maximum profit would be achieved if the price of the underlying asset is at the strike price of the front month sold short at expiration, rendering it worthless.
There are two basic types of call calendar spreads: the bullish, neutral call calendar spreads.
Using calls, the bull calendar spread strategy can be setup by buying long term slightly out-of-the-money calls and simultaneously writing an equal number of near month calls of the same underlying asset with the same strike price.
The trader applying this strategy is bullish for the long term and is simply selling the near month calls with the intention to ride the long term calls for free.
Once the near month options expire worthless, this strategy turns into a long call strategy, therefore the upside profit potential for the bull calendar spread becomes unlimited. Conversely, the maximum possible loss for the bull calendar spread is limited to the initial debit taken to put on the spread. This happens when the asset’s price goes down and stays down until expiration of the longer term call.
The neutral calendar spread strategy involves buying long term at the money calls and simultaneously writing an equal number of near-month at-the-money calls of the same underlying security with the same strike price.
For example, you might sell ABC September 50 Calls and Buy a November 50 Strike price call and for the spread to be effective, the September 50 strike price call would have to decay faster than the November 50 strike price call option.
The calendar spread is a debit spread, because you are paying more for the November 50 Strike price call then the premium that you are collecting for the September 50 strike price call option. Maximum profit would occur, if the stock at the time of the September option expiration, traded at or near the 50 strike price, this would cause the September 50 strike price option to expire, leaving you with an opportunity to profit from the November 50 strike price option, since you are long that call option.
Since the September 50 strike price call option has less time premium, it will decay faster and expire prior to the time the November 50 strike price option expires, giving you an opportunity to profit from time decay.
So as you can see, the primary goal of the calendar spread is to take advantage of time, because you want the short option, the near term option to expire worthless, while the long option, the November call option, to retain as much of it’s value or premium as possible.
Here's a simple scenario of a calendar spread, so you can get a better idea of how the trade set ups.
In September ZYX stock is trading at $100.00 per share, and you believe it will trade sideways for the next few months. So you go ahead and sell 1 November $100.00 strike price call option and at the same time buy 1 December $100.00 strike price call option. Since the December call option that you purchased has more time value it costs substantially more than the November $100.00 strike price call option, so the spread is initiated at a debit of $5.00.
Your maximum risk on this trade is $5.00, since that’s your total debit and that’s the most you can lose on this trade. Therefore, you should know that your maximum risk on a calendar spread is known at the time you initiate the spread, so there are no surprises later on.
The maximum profit on this spread cannot be ascertained at the time you initiate the spread, because we don’t know where ZYX stock will end up at the time the December call option that was purchased and we don’t know how high or low implied volatility will become, so there is a profit potential on this spread, but it is largely unknown at the time we initiate the spread.
The calendar spread makes sense from perspective of both probability and time premium, since the option that you sold, should theoretically decay faster than the option that you purchased, since options with less time value lose value quicker than options with more time premium, so assuming the asset stays near the $100.00 level, the November option will decay much quicker than the December call option and that’s when the spread begins to gain real value.
Say for example, at the time you initiated the spread, the November $100.00 call was priced at $5.00 per contract, while the December $100.00 was priced at $10.00 per contract.
Assume that ZYX stock stayed near the $100.00 level for 3 weeks and then you decided to liquidate the spread: The November call option that was sold, would now be worth $2.00, losing $3.00 due to time decay, while the December call that was purchased at $10.00, only lost $1.00 since it has approximately 1 more month of time value than the option that was sold, causing it to lose value slower in comparison to the option that was sold.
Assuming you liquidated the spread after approximately three weeks, you would sell the option that you purchased for $9.00 and buy back the option that you sold for $2.00. So you would end up liquidating the calendar spread for $7.00 while the purchase price was only $5.00, leaving you with a $2.00 profit on the spread, in just a few weeks, due to time decay.
As I mentioned earlier in this article, the calendar spread can be slightly adjusted depending on market conditions. I you believe that the asset is going to rise slightly, you may want to use strike prices for both options that you buy and sell that are slightly out of the money and if you don’t believe the underlying asset is going to move higher, you may want to stay with at the money options for both sides of the spread.
The ideal time to initiate a calendar spread, is usually shortly after earnings are released.
Statistically, stocks move the most starting a few days prior to earnings and typically revert back to lower volatility and trading range a few days after earnings are released. Therefore, it’s best to wait till after earnings are released to initiate the spread, since implied volatility will more than likely be inflated in the near term option that you are selling, resulting in more premium or credit for the position that was sold.