Calendar spreads can be a point of confusion for novice traders. The notion of trading for time value is not the most basic of concepts, and it can turn some beginners off entirely. However, there are several different scenarios where you could potentially use this strategy, and so many different ways to play the trade once it's been initiated -- it seems a shame to write off calendar spreads entirely. So, let's take a look at the nuts and bolts of this popular horizontal strategy.

Playing for time value

Your basic, garden variety, plain vanilla long calendar spread seeks to exploit the erosion of time value. The strategy consists of a shorter-term option, which is sold to open, and a longer-term option, which is bought to open. These options will share a common strike price, despite their unique expiration months.

In a strategy based solely on capturing time value, you should have a neutral forecast for the underlying equity. In other words, you're not expecting any major directional moves during the lifespan of your trade (or at least during the lifespan of the shorter-term option). Because you're neither bullish nor bearish, the position can be initiated using either puts or calls.

The ideal strike price in a time value-based calendar spread will be as narrowly out of the money as possible. You don't want your sold option to go in the money, which would raise the risk of assignment, but you also want to capitalize on the fact that at-the-money options will provide you with the maximum time value for your money.

The effects of time decay will be more pronounced on the front-month option, which means that you should be able to buy it back for next to nothing upon expiration. In fact, if it's out of the money and there's no risk of assignment, you could even let the option expire worthless if you so choose, thereby eliminating the need for an additional transaction (and boosting your bottom line that much more).

Meanwhile, your back-month option will still have at least a month's worth of time value left, which means that you should be able to collect a decent premium by selling to close upon the expiration of the front-month contract.

So, you collected a premium on the sale of the front-month option, and paid a premium to buy the back-month option. Because the latter carries more time value, the position will be opened for a net debit. However, selling to close the back-month option upon the expiration of the shorter-term option should net you the option's remaining time value. This premium, minus your net debit, is your maximum potential profit on the trade.

Because your short option position is hedged by a long option position, your maximum loss is limited to the initial debit paid to enter the spread. For example, say that you sold an October 35 put on XYZ, and simultaneously purchased a November 35 put on XYZ. Should XYZ fall below 35, you could be assigned. However, you can simply exercise your November option (which will also be in the money) in order to meet your obligations as an option writer.

As you might expect, this type of trade is best reserved for more advanced speculators. Not only do you have to accurately predict the stock's price action (or lack thereof) during the time frame of the trade, you're also buying and selling options in different expiration months. Plus, as noted earlier, the concept of trading for time value is rather abstract, and can be off-putting for beginners.

But, that's no excuse to shy away from horizontal spreads altogether. There are quite a few potential variations on this strategy, with possibilities for everyone from beginner to expert.

Variations on the theme

There are a few different ways to mix up your approach with a calendar spread. The first is probably the most basic: rather than closing out the long option when the front-month option expires, you can simply leave it open to capitalize on an expected directional move.

For example, let's say that you expect XYZ to hold steady above heavy options-related support during the month of October -- but you think the shares will resume their downtrend once this short-term floor expires. So, as with the previous example, you could sell the October 35 put and buy the November 35 put. However, once the front-month option expires (or is repurchased), you can leave the November-dated option as is, in order to benefit from the expected slide in the shares.

In this scenario, you have a longer-term directional forecast for the underlying equity, even though you expect neutral price action during the short term. By selling a front-month put and buying a longer-term put, you can capitalize on both expectations. You could also forgo the spread entirely and simply purchase the longer-term put, particularly if you're not confident in your short-term forecast. However, the sale of the shorter-term put reduces your cost of entry and your breakeven point, which is a nice bonus.

Also a nice bonus? Your profit potential is much, much greater once the calendar spread converts to a lone long put position (equal to the strike price of the purchased put minus the net debit, to be specific).

Another way to tweak your calendar spread is by adjusting the strike prices involved. If you expect modestly bullish price action during the lifespan of your trade, you can use call options that are out of the money. Alternatively, you can use out-of-the-money puts to build the trade if you're moderately bearish.

You can also turn you calendar spread into a three-legged monster, by rolling out your sold option from one expiration month to the next. You'll almost always want to sell the shortest-term option available, because this will reap you the maximum benefits of time decay. However, you can buy the long option up to two or three months out, depending upon your forecast for the particular stock -- leaving you plenty of room to roll.

For example, let's say that you've sold the October 35 put and purchased the December 35 put for XYZ. The shares remain stuck narrowly above $35 throughout October, and now expiration is rolling around. If you expect the equity will continue its range-bound ways during the near term, you could roll your October put into a November position.

By selling a November 35 put, you will have legged into another calendar spread. The purchased December 35 put is still out there to cover your short option position, so the premium you collect from the sale of the November put will simply minimize your net debit, or potentially even push your trade into the black.

Once November expiration rolls around, you have a few choices. You can close out both legs of the trade, thereby capturing any remaining time value on the December put. Or, if your expectations have turned bearish, you can let the long put position stand while exiting the front-month put.

In short, there's no need to feel hemmed in by the traditional definition of a calendar spread. There are many different ways you can edit this strategy to match your expectations, so don't be afraid to modify your approach.