Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

If an investor who sells an option contract expiring in a short period of time also purchases a contract with the same exercise price with a life which is longer than the contract which was sold, the investor has purchased a calendar spread.

During the holding period of the time spread, the option contract which is purchased will decline in value with the movement in time, but not nearly as quickly as the option which was sold.

In the money, and on the money Calendar Spreads have little chance of success, so we will concern ourselves with out of the money Calendar Spreads.

Calendar Spreads are often considered neutral strategies, but out of the money calendar spreads require you to have a modestly Bearish or Bullish bias on the underlying stock.

As an example, if a stock is trading at 25, and you sold a short-term $30 call, and bought a longer-term $30 call, your ideal situation is for the stock to remain below 30 until the near-term option (that you sold) expires, and then to move higher so the longer-term option increases in price. 

The biggest disadvantage is that if you are too successful in your prediction, and the price of the stock goes up over the strike price before the expiration of the shorter duration option, the spread begins to lose value, and it could happen that if the stock goes up far enough you would actually lose money on the spread.  Having your option prematurely exercised is also a possibility if the trade moves in the money.  In general, however, the risk of having your options prematurely exercised exists mainly in stocks about to go ex-dividend, so such trades should be avoided.

Calendar Spreads are purchased in a margin account, but no margin requirements is necessary because, theoretically, the purchased option has a longer life than the written option and, should the short contract be assigned, the long contract may be exercised, allowing the investor to purchase the underlying stock at the same price as it was called away.

Horizontal Calendar Spreads are always put on at a debit, since the longer-term option that you are buying always costs more than the shorter term option that you are selling.

Your stop on a calendar spread should be no more than one-half the debit, and no less than one-quarter of the debit.  Since the debits vary greatly, depending on the play you put on, this becomes a subjective decision based on your own risk tolerance.

Lets assume we want to put on a Calendar Spread on Cabot Microelectronics (CCMP) and further, we think the stock will go up in the long run.  Today is January 23rd and CCMP is selling at $48.

We could sell 8 April $55 calls, and buy 8 July 55 calls.  As a chart above shows the trade will cost us $2080 to put on (plus commissions), which is our maximum loss.

(Graph courtesy of OptionVue Systems)

Maximum profit occurs if the stock is trading right at the strike price (actually a penny below it) on expiration day of the April options.  Ideally, after the April options expire, CCMP would move higher, causing the July options to increase in value.  The chart above shows the value of this trade on expiration day of the April options.

By the same token, if we think the value of CCMP will go down, we could put on a Calendar Spread Using Puts.

We might sell  8 April $50 puts, and buy 8 July 50 puts.  As a chart above shows the trade will cost us $2160 to put on (plus commissions), which is our maximum loss.

(Graph courtesy of OptionVue Systems)

Once again, maximum profit occurs if the stock is trading right at the strike price (actually a penny above it) on expiration day of the April options.  Ideally, after the April options expire, CCMP would move lower, causing the July options to increase in value.  The chart above shows the value of this trade on expiration day of the April options.

There are a few things to keep in mind if you want to trade Calendar Spreads.  Among them:

1) You must be approved by your broker to trade calendar spreads.

2) Usually, the mistake traders make with Calendar Spreads, is not closing out the longer-term option when the shorter term option is closed out or expires.  There are times when it makes sense to hold the longer-term option but, in general, the dynamics of a spread are different then the dynamics of just being long an option, and the reasons for the trade don't justify holding the longer-term option.

3) The number of trades you can make in any month is limited by your available cash due to the margin requirements.

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