One of the characteristics of option trades that is particularly vexing to the new trader is the almost infinite variation in which individual options can be combined to produce a seemingly infinite array of choices. These combinations of the various individual options are more than a theoretical exercise; each individual combination often produces a unique Profit & Loss curve.
We have discussed previously the concept of a calendar spread. To review briefly, a calendar spread is constructed by selling a shorter dated option and buying a longer dated option at the same strike price in the same type of option, either puts or calls. The profit engine is the difference in the decay rate of the time premium between the two options. A fundamental characteristic of options is that the time premium embedded within a shorter dated option decays at a faster rate than that contained within a longer dated option.
Additional characteristics of this trade structure are that the range of profitability extends over a variably broad range and the maximum potential profitability occurs at options expiration when the price of the underlying is precisely at the strike price of the calendar.
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