A calendar spread, also known as a horizontal spread, is an options strategy that profits from the passage of time and differential implied volatilities between two options with different expiration dates. This non-directional strategy is typically implemented when the underlying asset is expected to remain relatively stable in the near term. It leverages the decay of extrinsic value, particularly theta.
Time
The core mechanism of a calendar spread exploits the time decay of options, where the shorter-dated option loses extrinsic value faster than the longer-dated one. The strategy involves selling a near-term option and simultaneously buying a longer-term option with the same strike price and underlying asset. This structural difference in expiration dates creates a positive theta position. Profit accrues as the front-month option expires worthless or loses value rapidly.
Volatility
Implied volatility differentials significantly influence the profitability of a calendar spread. The strategy benefits when the implied volatility of the longer-dated option increases relative to the shorter-dated option, or when volatility remains stable, allowing time decay to work. A rise in overall implied volatility can enhance the value of the long option more than the short option. Traders often initiate these spreads expecting stable prices and a subsequent increase in longer-term volatility.
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