Time Spreads, also known as Calendar Spreads, are an ideal way
to take advantage of time decay and changes in implied
volatility. The time spread strategy focuses on the movement of
time and volatility more than on the movement of the stock.
Therefore, this strategy is ideal for use when you anticipate
either stagnant or explosive periods in a stock.

The time spread, like other spreads, has its risks and rewards.
The risk is very limited for the buyer, but substantial for the
seller. The sellers risk can be avoided or contained with due
diligence at the expiration of the near months option. Also,
there are a variety of strategies that can affect the sellers
risk.

The advantage of this strategy is that the investor can pursue a
time decay or volatility position without the large capital
outlay necessary for the purchase of the stock.

Construction of the Time Spread

The construction of the time spread involves the purchase of one
option and the sale of another in different months, but with
both having the same strike. You can construct a time spread
using either two calls or two puts.

A long time spread is constructed by purchasing the out month
option and selling the nearer month option. For example, you buy
the September 45 call and sell the August 45 call or buy April
30 puts and sell February 30 puts. A short time spread is
constructed by selling the farther out month and buying the
nearer month. For instance, sell July 50 calls and buy May 50
calls.

The important elements in the construction of the time spread
are: use two call or two put options on the same stock, use the
same strike for both, choose different months for each and use a
one to one ratio. A one to one ratio means that you must
purchase one option for every one you sell or sell one option
for every one you buy. A time spread can utilize any two months
as long as it has the same strike price and the trade is done in
a one-to-one ratio.

Most time spreads are executed at-the-money because at-the-money
options have the greatest amount of extrinsic value. An options
extrinsic value is what decays over time and is the basis of the
time spreads strategy. Since the time spread is built to take
advantage of time decay it is naturally better suited for
at-the-money options.

This does not mean that the time spread can not be used
effectively with in-the-money or out-of-the-money options.
In-the-money and out-of-the-money options have less extrinsic
value than at-the-money options.

However, the rate of decay (discussed below) of an in-the-money
or out-of-the-money option with one month until expiration is
still greater than an in-the-money or out-of-the-money option of
the same strike that has three months to go before expiration.
This being said, the time spread can be constructed using any
option regardless if it is in, out, or at-the-money.