Series 3: 5.3.5.2. Calendar Spread Mechanics

Taken from our Series 3

5.3.5.2. Calendar Spread Mechanics

When a trader sells the nearby and buys the deferred month hoping that the spread will widen, he has bought a long calendar spread. It is called a long calendar spread because when you initiate the spread, you pay more for the distant option than you receive for the nearby option. The table below illustrates an at-the-money September-June call calendar spread, bought in March at a $50 strike price and offset in May at the same strike price. Note that the premium for the June call is lower than the September call in both months and that its rate of decline is greater. The spread has widened from negative five to negative eight. Since the call is at the money, the premium is all time value.

Calendar Spread	March	May	Gain/Loss
Jun 50 Call: premium	Sell at $10	Buy at $2	$8
Sep 50 Call: premium	Buy at $15	Sell at $10	-$5
Spread	-$5	-$8	$3

The picture gets more complicated when the price of the underlying goes in or out of the money. Suppose that the market price rises to $75. Both $50 calls are so far in the money that their premiums have no time value at all, only intrinsic value. Since both contracts have the same strike price, their intrinsic values are the same. Now the table looks more like the following. Note that the spread has narrowed to zero. Time value is greatest for at-the-money options and declines as prices diverge in either direction. If the price of the underlying goes well out of the money, time value for both options will fall to zero, and the loss on the calendar spread

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