A calendar spread is a strategy also known as a horizontal spread or time spread, in which the investor uses two options contracts, with the same strike price, on the same underlying security, but with different expiration dates.
The trader will “write” (sell) the near-term one (front month) and hold the one with the more distant expiration date (back month) long. This is a debit spread, since the investor will pay more to establish this position than is received from the short sale of the near-term option: longer-term options have a greater time value than short-term options.
Either calls or puts can be used to establish a calendar spread, but the two options should be of the same type.The investor will choose strike prices close to the current spot price of the underlying and hopes that there won't be much of a change in price. If the price of the underlying decreases or increases too much, it will result in a loss for the investor.
The good news is that the most the investor can lose is the net debit from establishing the position. The long leg will cover the risk of the short leg. Calendar spreads can be done with a neutral, bullish, or bearish outlook. If the options being used are at-the-money, the investor is neutral. Using the same strike prices slightly out of the money in one direction or the other will define a bullish or bearish outlook.
Using slightly different strike prices can be called a diagonal spread. The maximum profit is taken if the short position expires unused and the long position goes into the money. Increases in implied volatility without much change in the stock price of the underlying will result in increases in the prices of the options. The trader can sell the long option before expiration in this instance.
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