The term calendar spread refers to a neutral strategy that involves options with the same underlying stock and strike price but different expiration dates. Calendar spreads are a low risk, low return option strategy that profits from volatility and the passage of time.
Also referred to as a time or horizontal spread, a calendar spread is constructed using call or put options with identical strike prices, but different expiration dates. The outlook for the stock should be directionally neutral since the approach leverages the concept of time decay. That is to say, as an option contract approaches its expiration date, the ability to predict its terminal value also increases.
Calendar spreads are constructed using options of the same type (call or put) and the same strike price. For example, the investor can combine a short call with a near term expiration date and a long call with a longer-term expiration date. Since the strategy is neutral, both calls will be at-the-money or slightly out-of-the-money.
Due to decay, the near-term option will decline in value faster than the longer-term option. The maximum loss the investor can incur is the premium paid to establish the position. After the near-term option expires, the investor is left with a long call that possesses theoretically unlimited profit potential.