Calendar spreads and diagonal spreads are sophisticated options strategies that profit from the difference in time decay between options with different expiration dates. While they share similarities, understanding their differences can help you choose the right strategy for your market outlook and trading goals.
What is a Calendar Spread?
A calendar spread (also called a time spread or horizontal spread) involves buying and selling options at the same strike price but with different expiration dates. You sell the near-term option and buy the longer-term option.
Calendar spread structure: Sell a near-term option and buy a longer-term option at the SAME strike price. The goal is to profit from the faster time decay of the short-term option.
Example: Call Calendar Spread
Stock XYZ is trading at $100. You set up a calendar spread at the $100 strike:
- Sell 1x $100 call expiring in 2 weeks for $2.00
- Buy 1x $100 call expiring in 6 weeks for $4.00
- Net debit: $2.00 ($200 per spread)
- Max profit: Achieved if stock closes at $100 at near-term expiration
What is a Diagonal Spread?
A diagonal spread is similar to a calendar spread but uses different strike prices as well as different expiration dates. This adds a directional component to the trade.
Diagonal spread structure: Sell a near-term option and buy a longer-term option at DIFFERENT strike prices. This combines the time spread with a directional bias.
Example: Call Diagonal Spread (Bullish)
Stock XYZ is trading at $100. You set up a bullish diagonal spread:
- Sell 1x $105 call expiring in 2 weeks for $1.00
- Buy 1x $100 call expiring in 6 weeks for $4.00
- Net debit: $3.00 ($300 per spread)
- Max profit: Achieved if stock rises to $105 by near-term expiration
Key Differences Between Calendar and Diagonal Spreads
Strike Price Selection
Calendar Spread: Both legs use the same strike price. This creates a neutral position that profits most when the stock stays at that exact price.
Diagonal Spread: Uses different strikes, allowing you to express a directional view while still benefiting from time decay differences.
Directional Bias
Calendar Spread: Primarily neutral. You want the stock to stay near your strike price. The trade is more about volatility and time decay than direction.
Diagonal Spread: Has a directional component. Bullish diagonals benefit from the stock rising; bearish diagonals benefit from the stock falling.
Risk Profile
Calendar Spread: Maximum risk is the net debit paid. Maximum profit occurs at the short strike at near-term expiration. Risk profile is tent-shaped.
Diagonal Spread: Risk profile is more complex. Can be set up for a credit or debit depending on strikes chosen. Has more room for the stock to move in the anticipated direction.
How Time Decay Works in These Strategies
Both strategies profit from the differential in time decay between short-term and long-term options. Here is why this matters:
- Near-term options decay faster: Options lose time value at an accelerating rate as expiration approaches
- The short option decays faster: The option you sold loses value quicker than the one you bought
- The spread widens: As the short option loses value faster, the spread becomes more valuable
Important: Both strategies are hurt by the stock making a large move in either direction. Large moves can cause the long option to lose more value than you gain from the short option decay.
When to Use Calendar Spreads
Calendar spreads work best in specific situations:
- Expecting low volatility: You believe the stock will stay near the current price
- Low current IV, expecting increase: Calendars benefit from volatility expansion
- Targeting a specific price: You have a price target and believe the stock will reach and hold there
- Before earnings: Some traders sell near-term options before earnings and hold longer-term options
- Neutral outlook: No strong directional conviction
When to Use Diagonal Spreads
Diagonal spreads are better when:
- You have a directional bias: You expect the stock to move up or down over time
- Want reduced cost basis: Selling near-term options reduces the cost of your long position
- Planning multiple cycles: You can repeatedly sell short-term options against your long position
- Income on existing positions: Convert a long option into an income-generating position
- More flexibility: You want more room for the stock to move before the trade loses money
Managing These Strategies
Managing Calendar Spreads
- Close at 25-50% profit: Take gains when the spread widens sufficiently
- Roll the short option: When the short option expires, sell another short-term option
- Close early if the stock moves significantly: Large moves hurt the position
- Watch for IV changes: Volatility crush hurts calendars; IV expansion helps
Managing Diagonal Spreads
- Let the short option expire if OTM: Then sell another short-term option
- Roll up or down: Adjust the short strike as the stock moves
- Close the entire position: If your directional thesis changes
- Convert to a calendar: Roll the short strike to match the long strike if you become neutral
Side-by-Side Comparison
| Feature | Calendar Spread | Diagonal Spread |
|---|---|---|
| Strike Prices | Same | Different |
| Directional Bias | Neutral | Bullish or Bearish |
| Profit Zone | Narrow (near strike) | Wider (directional) |
| Complexity | Moderate | Higher |
| Best For | Range-bound stocks | Slow trending stocks |
Track Your Time Spreads
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Summary
Calendar spreads and diagonal spreads both leverage time decay differences between near-term and longer-term options. Calendar spreads are neutral strategies best for range-bound situations, while diagonal spreads add a directional component for traders who have a bullish or bearish view but still want to benefit from time decay. Both strategies require careful management and an understanding of how volatility affects options prices. Master these strategies and you will have powerful tools for profiting in various market conditions.
Continue learning with our guides on credit vs debit spreads and understanding Greeks for spreads.