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:
Sell 10 IBM Dec 100 calls
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.