More On Calendar Spreads
Calendar spreads, also called “time spreads” or “horizontal spreads,” are the only spreads we currently produce for the Web site. This is because they are especially easy to understand and to manage.
For the moment, let’s look at a typical time spread, say the LCOS long 1 Oct. 90 call @ $27.625 and short 1 June 90 call @ $15.00 (using Friday, May 28 closing prices). LCOS closed at $100.50 on Friday, so both calls had an intrinsic value of $10.50, and the time value of the Oct. 90 was $17.125 ($27.625 – $10.50), whereas the time value of the June 90 was $4.50 ($15.00 – $10.50).
The June call has 17 calendar days to expiration, whereas the October call has 136 calendar days to expiration, almost five months. Let’s look at the days to expiration and the time value of each of these two calls over the next 17 days until the June call expires:
| Days to Expiration: | 17 | 0 |
| Time Value Jun 90 | 4.5 | 0 |
| Days to Expiration: | 136 | 119 |
| Time Value Oct. 90 | 17.125 | ? |
I have left a “?” in the space showing the time value of the Oct. 90, because we don’t know what the price of LCOS will be in 17 days and we don’t know what the price of the Oct. 90 will be in 17 days. But you might suspect that with 119 days left to expiration, the Oct. 90 call would retain some appreciable time value.
You might compute the average loss of time value over their respective times to expiration of the two options. The Oct. 90 stands to lose $17.625/136 = $0.13 per day, while the June 90 stands to lose $4.50/17 = $0.265 per day; being long the Oct. 90 would cost you $0.13 per day and being short the June 90 would earn you $0.265 per day (assuming these calculations are logically correct).
This is a very naive calculation, but it is better than nothing, and the intuition behind it is basically correct, although a sharper analysis would give somewhat different results. In fact, the Oct. 90 will lose less than you have calculated, and if you have a computer program that computes the values of options at given prices for the underlying and times to expiration from theoretical considerations related to the behavior of LCOS, you can perform a much better analysis.
The cost of this spread is $27.625-$15.00 = $12.625, and such a program would tell you that it has a value of approximately $17.00. If you take this spread at these prices, your expected profit is $17.00 – $12.625 = $4.375. This is the kind of more precise information you can get from a computer program, which produces the values for our site, and it contains within it all the considerations pertinent to the problem, making it unnecessary to struggle with the kind of time decay analysis attempted above.