Chapter 2: Calendar and diagonal spreads (Calendar & Diagonal Spreads)
The two legs of a vertical spread differ in strike price. The two legs of a calendar spread differ in expiration date: the near contract loses its time value faster than the far one, and the trade profits from that difference.
| Sell a $510 call expiring next week | Collect $2.00 (high theta) |
| Buy a $510 call expiring next month | Pay $4.50 (lower theta) |
| Net amount paid | 2.50$ = 250$ |
| Max profit | When the Short Call expires at or near $510 |
Why does it profit?
If SPY stays near $510 through the end of the week, the short near-term contract expires nearly worthless, while the long far-dated contract keeps a large part of its time value because it still has weeks left. The difference between what remains in the far contract and what you paid ($2.50) is the profit.
Max loss
If the stock moves far in either direction, the two contracts approach the same value (both near zero on the way down, both intrinsic value on the way up), so the gap between them narrows. That is why max loss is about the net amount paid: $250 in the example.
Effect of volatility
The position gains when implied volatility rises, because the long far-dated contract is more sensitive to it (higher vega), and it suffers when volatility falls, because the far contract loses value. That is why the spread behaves differently around an earnings announcement: near-term volatility can fall more than far-term volatility after the report. The example here is for an asset with no event nearby.
Diagonal spread
Like a calendar, but with two different strikes as well: for example, buy a far-dated call at $500 and sell a near-dated call at $520. It combines collecting the near contract's premium with an upward lean, and the result changes with how close the stock gets to $520 when the near contract expires.
When to use it
- When you expect the price to stay near a certain level until the near contract expires.
- And when implied volatility is relatively low, you don't pay much for the far contract.
Summary
A calendar spread is a bet on time, not direction. It collects the decay of the near contract and keeps the value of the far one, and its max loss is about what you paid. It profits if the price stays near the strike, benefits when implied volatility rises, and suffers from big moves and from falling volatility. A diagonal adds a lean in a direction you choose.
