Time-based spreads such as a Calendar Spreads or Diagonal Spreads help you buy options with more time until Expiration (Back Month options) and sell options with less time until Expiration (Front Month Options).

Time Spreads take advantage of different Expiration Months, Implied Volatility and Time Decay. Selling and buying different months allows you to take advantage of Front Month Time Decay and Back Month Volatility.

For example: in a Short Option, the Front Month will have a higher rate of decay than the Back Month, and will have a different Implied Volatility. It also allows you to spread your Risk over multiple months rather than have it all in the same month as in Verticals. This gives you more time to be correct on your strategy.

Set up

• Sell At The Money (ATM) Call or Put Option Front Month.

• Buy same Strike Call Back Month Option.

• Use the same underlying asset but different contract Expiration Date based on Analytics accuracy. Since you are using the same underlying asset, the key is to get the timing correct. The optimal time till Expiration for Back Months is between 50 to 75 days, and for Front Months is between 20 to 40 days.

• Select Strike Prices based on Probability of Success and Tradespoon Analytics.

• Always keep in mind that it is a Debit Strategy and you are paying money up front.

Example

In the example graph given, you will notice that the maximum Gain you are getting is the Strike Price of your Short and Long Option. So any rapid movement to the Upside or Downside away from the Strikes will lead to heavy losses. Here the maximum Loss will happen at 39 and 45 and the maximum Gain happens at 42.

So, if you want to give yourself more time and take advantage of the time decay, especially when the Implied Volatility of the Front Month has jumped due to uncertainty in the market, then you have to execute this market neutral strategy with the hope that the Implied Volatility of the Front Months will decay and revert to its mean.

Key Takeaways

• Expiration: Calendars are buying strategies and hence you should sell the Front Month Options with approximately 20 to 50 days’ worth of time and buy the Back Month Option with 50 to 150 days’ worth of time.

• Strike selection: Your maximum gain on a Calendar Spread occurs when the price on Expiration day closes right at the Short Strike. When selecting a Strike to sell, you must contemplate where you anticipate the stock closing at Expiration. The advantage of Calendar Spreads is that you needn’t be 100% correct in this analysis, but it does pay off when you are!