Volatility Paradox

Overview

The Calendar Spread (also called a Time Spread) is a unique trade where you aren't betting on price direction, but on the speed of time.

By selling a near-term option and buying a longer-dated option at the exact same strike price, you are betting that the near-term option will lose its value faster than the long-term one.

[!NOTE] This is a Long Volatility trade. Even though you are short one option, the longer-dated option you bought has more "Vega" (volatility sensitivity) than the short one has.

The Setup

A Long Calendar Spread consists of:

Front-Month: Sell 1 Call at Strike $K$ , expiring soon.
Back-Month: Buy 1 Call at the same Strike $K$ , expiring later.

Mechanics: The Decay Differential

Why does this make money?

Options don't decay at a constant rate. They decay faster as they get closer to expiration.
In a Calendar, your short option is in that "fast decay" zone, while your long option is in a "slow decay" zone.
As long as the stock stays near the strike price, you "harvest" the difference between the two decay rates.

Payoff and Break-even

Max Profit

Unlike vertical spreads, there is no fixed formula for max profit at the start. It depends on the Implied Volatility (IV) of the back-month option when the front-month expires.

Maximum profit occurs if the stock is exactly at the strike price when the front option expires.

Max Loss

The net debit paid to enter the trade.

Break-even Points

Like Iron Condors, you have two break-even points, but they shift as volatility changes.

The "Vega" Advantage

Calendar spreads are highly sensitive to the Volatility Term Structure.

1. Vega: Long the Long-End

Because the longer-dated option has more time to expiration, it is more sensitive to changes in Implied Volatility. If the market gets nervous and IV rises, the back-month option will gain value faster than the front-month, helping your trade.

2. Delta: Neutral to Start

Calendars are typically entered "At-the-Money" (ATM), meaning they start with zero Delta. They are a way to make money without needing the stock to move.

When to Use?

Low Realized Volatility: You think the stock will stay pinned to a price in the short term.
Cheap Back-Month IV: You believe the longer-term options are priced too low relative to the short-term ones.

Checklist for Entry

Is the stock expected to stay near the Strike Price?
Is there enough of a "spread" between front and back month IV?
Have I considered if a Diagonal (different strikes) might be safer?

The Theta/Vega RatioRead more

Professional traders look at the Theta/Vega Ratio when evaluating calendars:

\text{Ratio} = \frac{\Theta_{\text{net}}}{\nu_{\text{net}}}

A high ratio means you are making a lot of money from time passing, but you are very vulnerable to a "Vega Crush" (volatility falling). Managing this ratio is the secret to consistent calendar spread trading.

Calendar Spread