As a strategy, calendar or time spreads are interesting, often profitable, and rarely used. A calendar spread involves the purchase of a longer term call option combined with the sale of a shorter term call option. You could also use puts in a calendar spread. The key point in the strategy is that both options have the same strike price.

For example, you could create a calendar spread on the iShares S&P/TSX 60 Index Fund (symbol XIU, recent price $17.93) by selling, say, the XIU May 18 calls at 25 cents, and buying the XIU July 18 calls 55 cents. Two calls with the same strike price, but different expiration dates.

The calendar has an out-of-pocket cost. You will always pay more for the longer call, than you will receive for the call you are selling. In the XIU example, the difference is 30 cents. For margin purposes, the call you bought effectively covers the sale of the short call. And finally, the most you can lose from a calendar spread is the net debit (in this example, 30 cents).

What makes the calendar spread appealing is the certainly of time value erosion. The closer the option gets to expiration, the faster time value erodes. Eventually falling to zero, if at expiration, the option is out-of-the-money.

The value of the May options (which expire in a 3 weeks) will erode at a much faster rate than will the July options (expiring in 13 weeks). Almost twice as fast, assuming the underlying stock remains in a relatively narrow trading range.

If XIU remains unchanged at the May expiration (i.e. $17.93 per share), this position will almost certainly be profitable. Why? Because at the May expiration, the July options will still have
9 weeks to expiry and would be worth around 43 cents.

The best case scenario, would see XIU close at exactly $18 per share at the May expiration. At that point, the May 18 calls would expire worthless, while the July 18 calls would be worth approximately 45 cents.

The calendar spread is based on mathematical certainties. The time component within the options price will decline to zero at expiration. More importantly, time does not decay in a straight line. The time value attached to the shorter option erodes faster than it does on the longer option.

But time value erosion is not the only thing that makes of this trade interesting. It is also attractive as a trade in a low volatility environment. Because, as volatility increases, it has a larger dollar impact on the longer term option.

There are risks of course. If the underlying stock should rise or fall substantially, the calendar spread will lose money. Because during a substantial movement, time value takes a back seat to the relationship between the strike price and the underlying stock price.

If the stock were to advance sharply, the short term call will rise at a faster rate than the longer term call. Eventually the calendar spread will start to lose money.

Ideally, with a calendar spread, you want the underlying stock to remain in a trading range, until the near month option expires. The XIU calendar spread should be profitable if the price of the stock remains between $17.25 and $18.75 until the May expiration. Above or below that range, the position will experience a slight loss, assuming volatility remains unchanged. But again, the potential loss is limited to the net debit paid.

Generally, you would not likely lose the entire net debit. As long as the July option had time remaining, it should have some value. Because if the underlying stock were to decline sharply, volatility would likely spike, and that would benefit the longer term call.