A calendar spread, or time spread, is a stock options trade in which the trader buys one option, then sells another with the same underlying market and strike price, but with a different month of expiration. The time value of an option – the contribution that the amount of time before expiration makes to an option's overall price_– decays faster the closer it is to that option's expiration. Different rates of time value decay for the two options in a calendar spread will cause the difference between their prices to increase, thus creating a profit for the trader. For this to work, the price of the underlying needs to stay relatively stable for the duration of the trade.
In a typical calendar spread, the trader will buy a distant month's option and sell a near month's option. Both transactions will occur for options at the same strike price. Based on time value alone, the distant month's option price will be higher than that for the near month's option and the trade entry is a debit transaction, or loss, for the trader. This cost of entry is equal to the difference between the two option prices.
As time progresses and if the underlying market price remains stable, the price of the sold option will decrease faster than the price of the bought option and the difference between the two prices will increase. The trader can then exit the trade, which is a credit transaction, at a higher overall price than the cost of entry. This results in a net profit for the trader.
To illustrate this, consider a hypothetical calendar spread. A trader wants to execute a spread on the futures for Commodity X. It is September. The trader purchases a January 50 option – an option that expires in January with a strike price of $50 US Dollars (USD) – for $8 USD and sells a November 50 option for $5 USD. The total cost of this transaction will be a debit of $3 USD.
When early November arrives, his or her November 50 option price has decayed to $2 USD, and his January 50 option price has decayed to $7 USD. He now sells his January 50 for $7 USD and buys back his November 50 for $2 USD, resulting in a credit of $5 USD. His total profit for the trade is the credit, $5 USD, minus the initial debit, $3 USD, which is $2 USD.
Another similar type of trade, though much less frequently used, is the reverse calendar spread. Here the trader sells the far out month's option and buys the near month's option. The trade entry is a net credit and will only end in profit if the difference between the prices of the options decreases. Two most common ways this happens is if price moves away from the strike or the overall implied volatility of the market shrinks while the trade is on.