Time Spreads in Options: Calendars and Diagonals in Practice

Why sell a call at the same strike as one you own? The dates differ. The call closer to expiration loses its time value faster. A time spread sells the fast-melting option and holds the slow-melting one. The profit, if there is one, is the gap between those melt rates.

The two legs

A calendar spread, sometimes called a horizontal spread, uses one strike and two expirations. You sell the near-term option and buy the longer-dated one. It opens for a debit.

Puts work as well. A put calendar at the 100 strike pays off in close to the same way as the call version, so the choice often comes down to which pair shows the tighter bid and ask on your chain, since you cross those quotes on two legs going in and two legs coming out. Check both before you pick.

The engine is time decay. Time value leaks slowly at first. In the last few weeks it pours out. So over the next 30 days, a 30-day option gives up all of its time value, and a 60-day option at the same strike gives up only part of its own. You are short the one that shrinks fast.

A worked calendar

The stock is a hypothetical company at $100. The chain shows:

• 30-day 100 call: $2.50
• 60-day 100 call: $4.00

Sell the 30-day, buy the 60-day.

Now jump to the front expiration, 30 days later. The short call is expiring. The long call now has 30 days left. It is the option the short call was on day one. If implied volatility has not changed and the stock is back at $100, a fair guess is that it trades near where the 30-day call traded at entry, about $2.50.

That is the best place for the trade to be. Move the stock away from $100 and the picture changes quickly.

If the stock runs to $110, the short call is worth $10 of intrinsic value, and the long call is worth a little more than $10, since it still holds some time value on top of the same intrinsic value. Suppose that extra is $0.80. The spread is worth $0.80, and you have lost $0.70 of the $1.50 debit. If the stock falls to $90, the short call expires worthless, but the long call is now well out of the money and might be worth only a few tens of cents. Either way, a big move in either direction pushes the spread toward zero, which is why the most a calendar at one strike can lose is roughly what you paid for it.

Those later prices are assumptions. Real prices depend on implied volatility at the time, and implied volatility is the part of a calendar that catches out anyone who treats it as a pure bet on time decay and a stock that stays still.

The volatility bet inside the time bet

The long leg has more vega than the short leg. So the spread gains when implied volatility rises. It loses when volatility falls, even with the stock on the strike, and a calendar opened while longer-dated volatility is high can lose money at exactly $100. Read the volatility term structure before you pair months. Calendar spreads are a bet on volatility argues that this is the trade.

Diagonals: a time spread with a lean

Change the strikes and the calendar becomes a diagonal. You might buy a 60-day 95 call and sell a 30-day 105 call. The long leg is in the money and moves more with the stock. The short leg sits above the price and collects time value. Now the time spread also wants the stock to rise, up to about the short strike. The diagonal spread entry works the payoff, and calendar spread vs diagonal spread sets them side by side for when you have a view on direction and when you do not.

Once the front leg expires, you can sell another near-term option against the long one. That is a roll. It is a new trade with its own price.

Calendars want a quiet stock at one price. Iron condors and butterflies sell a quiet market too, but with a single expiration and a range you choose, which is where the course goes next.