How does a calendar spread exploit time decay, and what market view does it express?

Question

AcadiFi · Accepted Answer

Calendar spreads are one of the most elegant theta (time decay) strategies, and understanding them requires grasping how time value decays at different rates depending on expiration.

**Construction (Long Calendar Spread):**
1. **Sell** a near-term option (shorter expiration) at strike K
2. **Buy** a longer-term option (farther expiration) at the same strike K

Both options have the same strike and the same type (both calls or both puts).

**Why It Works — The Time Decay Advantage:**

Time decay (theta) accelerates as expiration approaches. A near-term option loses value faster per day than a longer-term option at the same strike.

| Days to Expiry | Daily Theta (approximate) |
|---------------|-------------------------|
| 90 days | $0.04 per day |
| 30 days | $0.07 per day |
| 10 days | $0.12 per day |
| 1 day | $0.35 per day |

By selling the fast-decaying near-term option and buying the slow-decaying far-term option, you profit from the differential decay rate.

**Worked Example:**
Aurora Digital Payments trades at $150. You expect it to stay near $150 for the next month.

- Sell 1 March $150 call (30 days to expiry) at $4.80
- Buy 1 June $150 call (120 days to expiry) at $9.60
- Net debit: $9.60 - $4.80 = **$4.80**

After 30 days (March expiration), if stock is at $150:
- March call expires worthless: You keep $4.80
- June call (now 90 days to expiry) is worth approximately $7.50
- Net position value: $7.50 - $0 = $7.50
- Profit: $7.50 - $4.80 = **$2.70**

If stock has moved significantly (say to $170):
- March call expires at $20 intrinsic: You owe $20 - $4.80 = $15.20 net
- June call at $170 is worth ~$24
- Net: $24 - $15.20 = $8.80, but subtract initial cost of $4.80
- The profit depends on how much the June call's extra time value offsets the March call's intrinsic

**Key Characteristics:**

| Feature | Calendar Spread |
|---------|----------------|
| Direction | Neutral (profits if stock stays near strike) |
| Volatility view | Long vega (profits if IV increases) |
| Time decay | Profits from faster near-term decay |
| Max loss | Net premium paid (both options expire worthless) |
| Max gain | At front-month expiry if stock = strike |

**When to Use:**
- Expecting a stock to trade sideways near a specific price
- Implied volatility is low (you benefit if IV rises because the long-dated option gains more)
- Before a known catalyst that's after the near-term expiry but before the far-term expiry

**Exam Tip:** Know that calendar spreads are both neutral direction AND long volatility. The key profit driver is the differential time decay between the two options. Max profit occurs when the stock is at the strike at the near-term expiration.

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How does a calendar spread exploit time decay, and what market view does it express?

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