DESCRIPTION: A calendar spread entails buying a long-term put option while simultaneously selling a short-term put option with the same strike price. This is a short volatility strategy.
MOTIVATION: The investor has one of two strategies in mind, selling volatility or reducing the cost of purchasing a long dated option. Short dated options decay faster than long dated ones and have more gamma as well. As a result, a calendar spread will perform well if the price of the underlying security does not change very much. In this case, the short dated option can be bought back or allowed to expire allowing the investor to hold on to the longer dated put in anticipation of larger long-term move they might be anticipating.
OUTLOOK: The investor who buys a risk-reversal believes the share price will not change much over the life of the short dated option. At which point the trade is closed. If the investor is longer term bearish and they want to stay with a bearish posture, the investor buys it back the shorter dated option or lets it expire worthless and holds on to the longer dated put.
PROFIT/LOSS: Not well defined
For the time period of the near-term option, profit is limited to the extent the near-term option declines in value faster than the longer-term option. Since one leg of the structure remains, the profit or loss is affected by implied volatility used to price the remaining option.
BREAKEVEN: Not well defined
Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the price of the option at the expiration date of the near dated option. If the short-dated option expires worthless, breakeven would be above the strike price selected for the tow options
MAXIMUM GAIN: Not well defined
When the short dated option expires, the maximum gain would occur if the underlying stock sits at the strike price of the two options. If the stock is higher than the strike price, the expiring option would have intrinsic value. If the stock price is lower than the strike price, the longer-term option would have less value.
MAXIMUM LOSS: Premium Paid
The maximum loss occurs when the two options reach parity. This would happen if the underlying stock increased or decreased in value by an extreme amount. Under either scenario, the loss would be the premium paid upfront.
VOLATILITY: Positively correlated. An increase in implied volatility, all other things equal, would have increase the value of a calendar spread. Longer dated options have a greater sensitivity to changes in market volatility (vega).
TIME DECAY: Time decay works in favor of the structure. Since shorter dated option decay faster than longer dated ones, the value of a calendar spread will increase as time passes all other things held equal.
ASSIGNMENT RISK: Early assignment is always a possibility with an American style option. If the owner of the short dated option exercises their right to buy stock, the investor has to calendar spread will have to buy the stock back in the market or exercise their longer dated option to make delivery without borrow stock.
EXPIRATION RISK: Concerns what happens at expiration, which may not be in the control of the investor. Should the shorted dated put get exercised at expiration, the longer-term put option would still be in place to provide a hedge. If the longer dated option is held to expiration, the investor is in control of the exercise decision.