Construction: Long one call in one expiration month while simultaneously short one call at the same strike with a shorter expiration date. The strategy can also be used with puts. Because the longer-dated option will always cost more money, the strategy results in a debit.
Function: To collect time premium by taking advantage of options’ non-linear rate of decay. That is, all option prices decay over time, but longer-dated options decay at a slower rate as shown by the chart at the end of this section. Because the short-term option decays faster, the value of the Calendar Spread will widen (become profitable) over time if the stock price remains fairly stable.
When to Use: Best used during stagnant periods in order to collect premiums due to time decay. Unlike other premium collection strategies, the Time Spread offers limited losses whether the stock price rises or falls too far.
Breakeven: The strategy has two breakeven points, but you cannot calculate them with a simple formula because of the different expiration dates. When the short option is about to expire, the long option will still have some time value remaining, and you need to know that amount in order to calculate the breakeven points.
Max Gain: Gains are realized if the stock price remains between the two breakeven points at expiration of the near-term option. If the stock remains stagnant, the position will profit by the nearer month option (which you are short) decaying at a faster rate than the longer-dated month option (which you are long). When this occurs, the spread will widen thus creating a profit. Profit can also be attained if implied volatility increases. However, for the same reasons as with the breakeven points, you cannot calculate the maximum gain without a pricing model. The maximum gain is always achieved if the stock closes at the strike price at expiration.
Max Loss: The strategy loses some of its maximum potential gain if the stock moves away from the strike by either rising or falling. If the stock moves away, the spread will tighten, thus losing value. Losses are created if the stock moves outside of the breakeven points at the nearterm expiration. Maximum losses are realized if the stock makes a substantial move, whether up or down, when the near-term option expires. The maximum loss is the amount paid for the Time Spread.
Key Concepts: The strategy is best done with at-the-money options where the extrinsic value is the highest, which accentuates the rate of decay. Best results are found in stocks that are in a stagnant period because stock movement away from the strike will lead to losses. The reason the strategy works is because of the passage of time.
Example: Buy one April $50 call for $4, sell one January $50 call for $2, for a net debit of $3. If the stock is $50 at January expiration, the short option will have lost 100% of its value while the long call will lose less, say 50 cents, so the difference between the two options will widen to $3.50. If the stock price rises or falls a small amount, the maximum gain will be reduced. However, if the stock price falls significantly, both option prices get close to zero, leaving you with a loss of the original $3 debit. If the stock price rises significantly, both options converge to their intrinsic values, and the difference between both options again converges toward zero leaving you with the maximum loss of $3.