Calendar Spread

In calendar spread, we enter a long and a short position at the same time on the same underlying asset at the same strike prices, but with different expiration months. Also, both options are of the same type, meaning strategy can be created with either both calls or both puts. The basis for this strategy is that the closer we get to the expiration the faster the time decay.

Strategy

Short position in a call or put option with a certain strike price with expiration ‘t’ and a long position in a call or put option with the same strike price with an expiration ‘T’ such that T > t.

Sell near-term Call/Put

Buy longer-term Call/Put

The logic behind this strategy is that when you short the near-month option, you’ve got that quickly-evaporating time premium working for you which is faster than the decay in the further out option that you have bought. So, the calendar spread can be used to take advantage of a difference in the implied volatilities between two different months' options. The trader will ordinarily implement this strategy when the options, he is buying, have a distinctly lower implied volatility than the options he is selling.