Part IV       (Parts I, II, and III)

This lengthy (for a blog) discussion is not meant to be a comprehensive study of how to trade
calendar spreads.  It's intended to help the options rookie gain an understanding
of this popular strategy and to help those who are already using this
method to get a clearer understanding of how it works.

The Greeks

There exists a set of mathematical parameters that help define risk characteristics associated with options.  Those characteristics are identified by Greek letters and are usually know as the 'greeks.'
They are used to give traders a good estimate of how much the value of
an option changes as market conditions change.

1) The
passage of time is beneficial to the spread owner because the near-term
option loses more value per day than the longer-term option.  The Greek letter that measures time decay is theta – and the Dec option has a greater theta than the Jan option. Theta is defined as the rate at which the value of an option decreases with the passage of one day.  Theta increases as expiration nears.

2) As the
stock moves further away from the strike price, the calendar spread
loses value.  Despite the gain that come from the passage of time, the market price of the Dec option changes
(increases or decreases) at a rate that is unfavorable to the owner of a calendar spread.  In simple terms, when the stock rallies beyond the strike price, the December option rises faster than the January option.  When the stock falls below the strike price, the December option loses value more slowly than the January option.

This is a result of the combination of delta and gamma.

Delta measures the rate at which the value of an option changes when the stock moves one point.

Gamma measures the rate at which delta changes when the stock moves one point.

In very simple terms, if an option has a delta of .50 and a gamma of 0.05 (when speaking, we say delta is '50' and gamma is '5'), then when the stock rises by one dollar per share, the option value should increase (all else being equal) by about 52.5 cents and the option delta increases to 55.

Why 52.5 cents and not 50 cents?  Because delta was '50' at the start of the move and '55' at the end.  The average delta is '52.5'

When the stock price is near the strike price of, both options have a delta near 50 (let's not quibble, I'm trying to keep this simple), and the December call has a higher gamma than the January call.

When the stock moves further away from 100 in a positive direction, the December call gains delta faster than the January call (because it has a higher gamma) and thus the value of the January call lags behind.  You can see the effects of this price change in the table presented in Part III.

When the stock moves further away from 100 in a negative direction, the
December call loses delta faster than the January call (because of higher gamma) and thus the value of the January call falls faster than the December call.  See the table in Part III.

Whichever way the stock moves –
it's not good for the owner of a calendar spread.  If the move is not
very significant, the spread owner should earn a profit.  When the move is