5.3.5.1. Calendar Spreads and Time Value
The first thing to understand about calendar spreads is that the longer-term option (the deferred option) generally has more time value than the shorter-term option (the nearby option). This should be obvious enough, since the cash price of the underlying product will have more time to rise or fall prior to the time the deferred option expires. As a result, the deferred option can be expected to have the higher premium.
For any option, whether nearby or deferred, the time value of its premium is always greatest when an option is at the money. At this point, any price movement of the underlying cash commodity will tip the option either in or out of the money. When the underlying price veers sharply from the strike price in either direction, time value will decline.
In addition, time value declines faster for a nearby option than a deferred option because the price of the underlying has less time to move off the current market price. Since the time decay for the nearby option is greater than for the deferred option, the premiums of the spread have a tendency to widen as the spread moves toward its first expiration date.
Example: Consider the following at-the-money calendar spread.
Short XYZ Mar 40 Call @ 2 (nearby option)
Long XYZ Sep 40 Call @ 5 (deferred option)
Because this spread is at the money, the time value of each premium is at its greatest. Suppose that the market price of the underlying rises to $45. Both premiums now have an intrinsic value of $5, and the time value of both has decayed, with the nearby option decaying faster. The premium of the short call is now $6 and the premium of the long call is $9.50. The spread has widened from $3 to $3.50. When the investor closes out his position, he will now receive $3.50, netting $0.50.
Now suppose instead that the market price of the underlying dropped to $35. Both options are out of the money, and their time value has declined according to their