A calendar spread is a neutral, defined risk strategy used to establish a long volatility position, while still collecting theta in the short term. To create a calendar spread, we sell a near-term expiration option and buy a long-term option at the same strike price. Ideally, we want the short option to close to ATM or slightly OTM so that our theta decay is maximized, reducing our cost basis significantly. Because our short option’s expiration is always less than our long option’s expiration, we have the opportunity to reduce cost basis multiple times by rolling the short option.
It is important to note that volatility effects long-term options more than short-term options. Although an increase in volatility may negatively affect our short-term option, it will be positively offset by our long-term option. With that said, the most important thing to keep in mind is that we want our short-term option to expire ATM, or slightly OTM.
Due to the nature of a calendar spread, we buy them in low volatility environments with the assumption that the underlying’s price will hover in a tight range for a specified period of time (the expiration of our long option). More importantly, we hope that there is an expansion in volatility so we have an opportunity to reach maximum profit. Profit is still achievable if volatility stays the same or decreases somewhat, but the break-even points are much tighter respectively.