When running a calendar spread with calls, you’re selling and buying a call with the same strike price, but the call you buy will have a later expiration date than the call you sell. You’re taking advantage of accelerating time decay on the front-month (shorter-term) call as expiration approaches. Just before front-month expiration, you want to buy back the shorter-term call for next to nothing. At the same time, you will sell the back-month call to close your position. Ideally, the back-month call will still have significant time value.
If you’re anticipating minimal movement on the stock, construct your calendar spread with at-the-money calls. If you’re mildly bullish, use slightly out-of-the-money calls. This can give you a lower up-front cost
Because the front-month and back-month options both have the same strike price, you can’t capture any intrinsic value on the options. You can only capture time value. However, as the calls get deep in-the-money or far out-of-the-money, time value will begin to disappear. Time value is maximized with at-the-money options, so you need the stock price to stay as close to strike A as possible.
For this Play, I’m using the example of a one-month calendar spread. But please note it is possible to use different time intervals. If you’re going to use more than a one-month interval between the front-month and back-month options, you need to understand the ins and outs of rolling an option position.
Maximum Potential Profit
Potential profit is limited to the premium received for the back-month call minus the cost to buy back the front-month call, minus the net debit paid to establish the position.
Maximum Potential Loss
Limited to the net debit paid to establish the trade.
NOTE: You can’t precisely calculate your risk at initiation of this strategy, because it depends on how the back-month call performs.
Break-even at Expiration
It is possible to approximate break-even points, but there are too many variables to give an exact formula.
Because there are two expiration dates for the options in a calendar spread, a pricing model must be used to “guesstimate” what the value of the back-month call will be when the front-month call expires. TradeKing’s Profit + Loss Calculator can help you in this regard. But keep in mind, the Profit + Loss Calculator assumes that all other variables, such as implied volatility, interest rates, etc., remain constant over the life of the trade — and they may not behave that way in reality.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required if the position is closed at expiration of the front-month option.
As Time Goes By
For this strategy, time decay is your friend. Because time decay accelerates close to expiration, the front-month call will lose value faster than the back-month call.
After the strategy is established, although you don’t want the stock to move much, you’re better off if implied volatility increases close to front-month expiration. That will cause the back-month call price to increase, while having little effect on the price of the front-month option. (Near expiration, there is hardly any time value for implied volatility to mess with.)