Calendar and Double Calendar Spreads
Calendar spreads are created by buying an option in a future expiration month and selling an option at the same strike price in the current or front expiration month. Calendar spreads are also known as time spreads or horizontal spreads. The horizontal spread terminology derives from the original boards in the exchange used to post option prices. When we create the calendar spread, we are buying and selling options in the same row (same strike price) but in different columns (different expiration months), hence the horizontal spread.
As we saw earlier, one of the factors determining an option’s price is the remaining time before the option expires. As the price drops due to less time remaining to expiration, we refer to this phenomenon as time decay. But that time decay is not a linear function; it accelerates as the date of expiration approaches. The profitability of the calendar spread is built on the differential in time decay between the front-month option and the longer-term option. We have sold the front-month option, and it is decaying in price faster than the longer-term option that we own.
We will create a calendar spread with Apple Computer (AAPL) to illustrate the basic characteristics of this spread. On February 12, 2010, AAPL was trading at $200, and we created a $200 Mar/Apr call calendar spread for a debit of $340. The risk/reward graph is illustrated in Figure 6.1.