Calendar Spreads Part I

Let's begin with a definition: A calendar spread is a position consisting
of two options.  One is bought and the other is sold.  Both options are
of the same type (both calls or both puts), have the same underlying
and strike price, but different expiration dates.  If you buy the
option that expires later, then you BUY the calendar spread.  When you
buy the option that expires first, then you SELL the calendar spread.

Many
individual investors buy calendar spreads, sometimes called 'time
spreads.'  This is one of the most popular trading strategies in use. 
Yet, I have never written about calendar spreads.  It's not that I
disapprove of calendars, but this strategy involves  something that I
prefer to avoid – and that's predicting market direction.  As you will
see (in a later installment), to be successful as a calendar spread trader, you must make a
reasonable estimate of where the underlying stock (or index) is headed
between the time you buy the spread and the time the near-term option expires.

I
currently buy iron condors, which are profitable when the underlying
remains within a range – but that range can be much wider for iron condors
than for calendar spreads.  Thus, there's less emphasis placed on
predicting the future price of a stock.

When
opening the trade, the vast majority of investors buy, rather than sell, calendar spreads. One reason is that margin rules dictate that being short a
calendar spread is equivalent to being naked short the option that expires
later.  Some brokers don't allow their customers to adopt such a
strategy – but even when they do, the margin requirement is steep.

Here's an example of buying a calendar spread:

Note:
The options do not have to expire in consecutive months.  The number of
months between expiration dates is immaterial; it's still a calendar
spread when both options have the same strike price.

Why buy a calendar spread?  How does it earn a profit? 

The
idea behind the calendar spread is to take advantage of the fact that
the near-term option decays at a faster rate than the long-term
option.  Thus, all else being equal, as time passes the value of the
spread increases.

But, it's not quite that simple.  If the rate
of time decay were the only factor, this type of spread would almost
always be profitable.  These spreads can lose money because other factors come into play when determining the ever-changing value of a calendar spread.  I'll discuss how that happens in a later installment.

To be continued…

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