Calendar Spread

The calendar spread is a debit trade – meaning you pay to put on this strategy.  You sell the near-term option and buy the far-term option at the same strike price at different expiration months.  You will collect premium for selling the near-term option and you will pay premium for buying the far-term option. 

When you put on this trade, the debit you pay will be the difference in the time-value portion of the premium for each leg.  As time passes, this net difference will either get bigger, or smaller.  Ideally, you want to close the position when net time value is at its peak.  That is the top of the “witch’s hat” in the profit curve pictured above.

Ideally, the near-term option expires worthless -- one penny below its strike price (time value = 0).  In this ideal scenario, you reap whatever time-value is left in the far-term option (which you hope is substantial) and you sell that option on the open market, closing the entire spread position.

With a calendar sread strategy, the profit scenario unfolds over time and there are often decisions to be made along the way.  For instance, if the near-term option expires way out-of-the-money, you will be left holding a far-term call option with a month or two left to go until expiration.  For many traders, that scenario smells like opportunity.  The money collected for writing the near-term option is in the bank and the remaining long call option has a few months to go before expiration.  Even though that call is way out-of-the-money, the trader sees plenty of time for the stock price to rally back and deliver a handsome return.

Be careful, though.  More than likely, that out-of-the-money call will expire worthless and you will lose the maximum amount possible with this strategy.  It is sometimes best to close out a calendar spread, even at a loss, and live to fight another day.