Calendar spreads, also known as time spreads, are useful when you are uncertain about the direction of the market but you want to implement an effective option hedge during periods of market volatility. Of course, you can tailor your calendar spread to meet a bullish or bearish bias, and we will be looking at calendar spreads with a bearish bias in this article.
A bearish calendar spread consists of two options: a long put option and a short put option.
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Long put option: The first option is a long put with a long-term expiration date. Traders will usually use LEAPS or options with expiration dates longer than a year for this option. The long-term put establishes the bearish bias for the trade and will grow in value as the market drops.
Short put option: The second option is a short put with a short-term expiration. The short put has the same strike price as the long put you purchased. The identical strike price but different expiration dates is what makes this a calendar spread.
When you enter a bearish calendar spread, you must pay for the long put option but you receive a premium for selling the short put option. The ratio of the premium received from the short put to the price you paid for the long put is much larger than the ratio would be in a diagonal spread.