🗓️ Calendar and diagonal spreads: trading time itself

🎯 In 30 seconds: A calendar spread sells an option that expires soon and buys the same strike further out. A diagonal does the same with different strikes. The near option loses value faster than the far one, so if the stock stays near the strike, the spread gains. Because the two options expire on different dates, there is no single fixed payoff line: the result depends on implied volatility when the first option expires. The max loss is roughly the debit you paid. The "poor man's covered call" is a diagonal that copies a covered call with far less cash, and with its own risks.

Why time can be traded

An option's price has two parts: intrinsic value and time value (see What an option is worth). Time value shrinks to zero by expiration. It does not shrink evenly. It shrinks slowly when expiration is far away and fast in the final weeks. That rate of decay is theta, one of the Greeks.

Here is the effect with a pricing model. A $100 call on a $100 stock, 30% implied volatility, 4% interest. The stock stays at $100 the whole time.

Over the same 30 days, the 60-day option drops from $5.17 to $3.59, a loss of $1.58. The 30-day option drops from $3.59 to zero. If you sell the 30-day and own the 60-day, you are short the fast-decaying option and long the slow one. That is a calendar spread.

The call calendar, step by step

Also called a time spread or horizontal spread. Hypothetical example, prices from the same model:

On the day the short call expires, there are three broad cases:

• Stock still at $100. The short call expires worthless. Your long call has 30 days left and is worth about $3.59, if implied volatility has not changed. Value $3.59 against the $1.58 you paid: about +$201. This is the best case.
• Stock far below $100, say $80. The short call expires worthless, but your long call is far out of the money and worth very little. You lose close to the full debit, about -$157.
• Stock far above $100, say $120. The short call is $20 in the money. Your long call is worth a bit more than $20, but almost all of that is intrinsic value. The two nearly cancel, and you lose close to the debit again, about -$120.

Why the payoff line is an estimate

For a spread with one expiration, the payoff at expiration is exact: each option is worth its intrinsic value. A calendar has two expirations. When the first one expires, the long option is still alive, and its price depends on implied volatility at that moment. Nobody knows that number in advance.

So the chart above uses a model and an assumption. The blue line assumes implied volatility stays at 30%. The dashed line assumes it falls to 25%. With lower implied volatility, the peak drops from about $201 to about $144, and the breakeven range narrows. Treat the breakevens of about $95.20 and $105.80 as estimates, not promises.

Two numbers are firm. The max loss is about the debit, $158, because the long call can never be worth less than nothing and the short call's loss above $100 is covered by the long call. And the profit is highest near the strike on the first expiration date.

The role of implied volatility

A calendar is long vega: you own the option with more time, and longer options are more sensitive to implied volatility. If implied volatility rises, the long option gains more than the short one, and the spread gains. If it falls, the spread loses, even with the stock pinned at the strike. See Implied volatility.

Implied volatility is not the same for every expiration. Before an earnings report, the expiration just after the report usually carries higher implied volatility than later ones. Some traders sell that expensive near-term option and buy a later, cheaper one. When the report passes, the near option's implied volatility collapses. That can help the spread, but a big earnings move can push the stock far from the strike, which hurts it. The higher premium is there because the risk is real.

Diagonal spreads

A diagonal is a calendar with different strikes: you buy a longer-dated option at one strike and sell a shorter-dated option at another. Changing the strikes tilts the spread toward a direction. A diagonal with a long lower-strike call and a short higher-strike call is mildly bullish.

The most common diagonal is the poor man's covered call. It copies a covered call, but replaces the 100 shares with a deep in-the-money call that has a long time to run.

The poor man's covered call, worked

Hypothetical example with a $100 stock and 30% implied volatility.

When the short call expires, if implied volatility is unchanged, the model gives:

• Stock at $105: the short call expires, the long call is worth about $29.74. Profit about +$549.
• Breakeven: about $98.70.
• Stock at $70: the long call has lost much of its value. Loss about -$1,893.
• Max loss: the full $2,425 debit, if the stock falls and stays below $80 until the long call expires.

The appeal is clear: similar upside to a covered call for about a quarter of the cash. The problems are also real:

• Leverage cuts both ways. A drop to $70 costs a covered call writer $3,000 - $165 = $2,835 on $9,835, or 29%. It costs the poor man's version about $1,893 on $2,425, or 78%. See Leveraged products.
• No dividends. Owning a call does not pay you the stock's dividends.
• Early assignment. If your short call is assigned, you are suddenly short 100 shares. You can exercise your long call to deliver them, but exercising throws away its remaining time value. It is usually better to sell the long call and buy shares, or close both legs.

Managing calendars and diagonals

• Roll the short leg. When the near option expires or is nearly worthless, you can sell another one against the same long option. This is how a poor man's covered call collects premium month after month.
• Close before the short leg expires if the stock is near the strike. That is when the spread is worth the most and pin risk is highest.
• Watch the long leg's time. Once the long option itself gets close to expiration, it starts decaying fast too, and the spread no longer works the way it did.

Try it

Pick a stock from your Watchlist without earnings in the next 60 days. On its options chain, price an at-the-money call calendar using the expiration about 30 days out and the one about 60 days out. Write down the debit and the implied volatility of each leg. On the day the short leg expires, record the stock price, the long call's price and its new implied volatility. In your trading journal, note how much of the result came from the stock's move and how much from the change in implied volatility.

Sources

• Options Industry Council (OIC): Long call calendar spread (call horizontal)
• OIC: Theta
• OIC: Vega
• OIC: Black-Scholes formula