Editor's Note: In the column below, originally published Feb. 26, we gave a bum steer on the explanation of exactly what makes a spread a calendar spread.
In responding to reader Bill Tucker's question, we mistakenly said: Essentially, a calendar spread is an options strategy for when you feel bullish or bearish about an underlying stock, but lack confidence as to the timing of your hunch.
To play on the time element of options, you can buy or sell options with a few months, or even years, in between expiration dates. (Usually with a calendar spread, the options expiration date is different, but the strike price is the same.)
In fact, a calendar spread is the simultaneous sale of a short-dated option and the purchase of a longer-term option with the same strike price. You don't buy both, as we suggested; you sell one and buy another. In addition, it's best used as a strategy when you're feeling neutral and have no real belief that the stock will move far in either direction.According to Larry McMillan's Options as a Strategic Investment, the idea is that "time will erode the value of the near-term option at a faster rate than it will the far-term option." Here's an example from the same chapter in McMillan: A stock is at 50 -- you sell the April 50 call for 5 and buy the July 50 call for 8. The cost of that investment is the 3-point difference between what you take in for the April call and what you spend on the July call. The difference comes from the increased time value portion of the option's premium. Because that time value erodes as the options get closer to expiration, if the stock is still sitting at 50 by the April expiration, the call you sold expires worthless and the July call is now 5. That means the profit from the trade is 2 (5 minus 3). Again, this works well when you're not expecting the stock to move. Selling options, especially near-term ones, can be a costly exercise if the stock moves beyond the strike price. In the case of calls, you'll have to go out and buy the stock and then sell it at a lower price (the strike price) to fulfill your end of the contract; if it's a put, you may end up paying 50 for a stock that's worth 55 and be forced to hold onto it for another two months, when the put you bought expires.