Also known as a time spread or horizontal spread, a calendar spread is a position constructed using two options of the same type (either calls or puts) where one is bought and another is sold at the same strike but for different expirations. There are call calendar spreads and put calendar spreads.
In a calendar spread, the near-term option is sold and the back month option is bought as a hedge. Because the back month option being bought has more time value than the near-term option being sold, a calendar spread is done for a debit.
The aim is to collect the faster decay from the short-dated option since time value erodes more quickly than in the back month option. These are commonly used when price is expected to stagnate (non-directional) over the life of the near-term option, or when price is expected to move (directional) toward a particular strike by expiration. The calendar spread expands, or gains value, as time passes while price stays near the strike price.
A trader could sell a naked call or a naked put if price were expected to stagnate, but those strategies lack a hedge. In a calendar spread, the long back month option serves as a hedge, thereby limiting potential profits but also limiting risk.
Calendar spreads tend to retain at least some value even if price moves a considerable distance from the strike price. This is because even once the near-term option expires, the long option (initially the back month option) still has time and therefore some value. A calendar spread is net long vega, so it will benefit from an increase in implied volatility.
A reasonable profit target for a calendar spread is 50% above what was paid for the position, although some profitable calendar spreads never achieve this and others may exceed this target.
For example, a call calendar in XYZ at the $40 strike would include a short $40 call for the near-term expiration, and a long $40 call for the back month expiration. If purchased for a $0.50 debit, then a reasonable profit target may be $0.75 (50% above the price paid).
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