Calendar Spreads

A vertical spread plays two strikes. A calendar spread plays two dates. You pick one strike, sell the option that expires soon, and buy the option that expires later. Both are the same type, same strike — only the calendar differs, which is where the name comes from (it's also called a time spread or horizontal spread).

Why would that make money? Because time value doesn't drain out of options at a steady rate. A near-dated option is running out of runway fast, so it loses value quickly; a far-dated option has plenty of time left and decays slowly. Sell the fast-decaying one, own the slow-decaying one, and you collect the difference in decay. The trade profits most when the underlying sits quietly near the strike while the short option withers away, leaving you still holding the long one.

The engine: time decay isn't linear

A rough but reliable rule of thumb is that an at-the-money option's value scales with the square root of time left:

$$\text{time value} \;\approx\; 0.4 \times S \times \sigma \times \sqrt{T},$$

where $S$ is the underlying price, $\sigma$ its volatility, and $T$ the time to expiry in years. The $\sqrt{T}$ is the whole story: halving the time left doesn't halve the value, it multiplies it by $\sqrt{0.5}\approx 0.71$. As $T$ approaches zero the curve steepens, so the last few weeks decay fastest. That is the decay you sell.

Worked example

A stock trades at $100. You set up a calendar spread at the $100 strike:

• Sell the 1-month $100 call for $3.
• Buy the 3-month $100 call for $5.
• Net debit = $5 - 3 = 2$. That is roughly your maximum risk.

Now fast-forward one month, and suppose the stock is still around $100. The short call, now expiring, is worth essentially nothing — you keep the full $3 of premium you sold. Meanwhile the call you own has become a 2-month $100 call, still at the money, worth about $3.5. You spent $2 net; you now hold something worth roughly $3.5, a tidy profit. The near option's decay paid you while your long option barely aged.

But suppose instead the stock rockets to $130. Both calls are now deep in the money and behave almost identically (deltas near 1), so the short leg's loss and the long leg's gain nearly cancel. The spread's time-value edge evaporates because deep options have little time value left to differ over — you end up near breakeven or a small loss. A calendar spread wants the stock to stay put, not to run.

Where it misleads

• A big move either way hurts. The profit is a tent pitched over the strike. Drift far in either direction and both legs lose their time value together, collapsing your edge. A long calendar is quietly short large realized movement.
• It's a volatility trade in disguise. You are long vega, so you want implied volatility to rise (or at least hold) before the near expiry. If implied vol falls after you put the trade on, the long leg loses value and the spread suffers even if the stock behaves.
• Term structure can work against you. If near-term implied vol is much higher than far-term (a backwardated vol term structure, common in a panic), the near option you're selling is already cheap relative to the far one you're buying, and the usual edge can invert. Check the term structure before assuming the near leg is "expensive."

Calendar spreads complete the trio of basic option structures: Vertical Spreads trade the strike, Straddles and Strangles trade the magnitude of the move, and calendars trade time and the shape of the volatility term structure. The decay that powers them is measured directly by theta, and their volatility exposure by vega.