An options strategy that works well if you belong to the “sell in May and go away” camp is the “calendar” (or “time”) spread.

This is also a good strategy in a low-volatility environment, such as the one we are in now, as the Chicago Board Options Exchange’s volatility index (symbol: VIX) is at the low end of its range and well below its 200-day rolling average.

The calendar spread involves the purchase of a longer-term call option combined with the sale of a shorter-term call option.

You could also use puts in a calendar spread, but the key with the strategy is that both options have the same strike price.

You could create a calendar spread on the S&P 500 depositary receipts (symbol: SPY), which trade on the New York Stock Exchange and were recently priced at US$134.26, by selling, say, the SPY June 134 calls at US$3.25 and buying the SPY September 134 calls at US$5.50. Both options are calls with the same strike price. The difference — and the reason it’s called a calendar spread — is the expiry months.

The calendar spread has an out-of-pocket cost. You will always pay more for the longer call than you will receive for the call you are selling. In the SPY example, the difference is US$2.25. For margin purposes, the call you bought effectively covers the sale of the short option. From a risk perspective, the most you can lose from a calendar spread is the net debit (in this example, US$2.25).

What makes the calendar spread appealing is the certainty of time-value erosion. The closer the option gets to expiry, the faster time value erodes. Eventually the time value falls to zero — if at expiry, the option is out of the money.

Thus, the time value of the June options, which expire on June 18, will erode at a much faster rate than the September options — almost twice as fast — assuming the underlying stock remains trading in a relatively narrow range.

If SPY is at or below US$134 at the June expiry, this calendar spread position will almost certainly be profitable. Why? Because at the June expiry, the September options will still have 15 weeks to expiry; and assuming SPY is trading at US$134, the September options would be worth about US$3.80. The net cost for the spread was US$2.25 — and you are now long September calls worth US$3.80.

The calendar spread is based on mathematical certainties. The time component within the options price will decline to zero at expiry. Furthermore, as time does not decay in a straight line, the time value attached to the shorter option erodes faster than it does on the longer option.

However, time-value erosion is not the only thing that makes this strategy interesting. It is also attractive as a trade in a low-volatility environment because, as volatility increases, it has a bigger dollar-value impact on the longer-term option.

For example, the prices used in the SPY example assume a 17.8% implied volatility. But suppose we apply, say, a 25% implied volatility assumption to the options when the position is established (i.e., with SPY at US$134.26 a share). At that volatility, the June 134 call premiums would be US$4.80 vs US$7.30 for September 134 calls. The difference: US$2.50.

There are risks in using the calendar strategy, of course. If the underlying stock’s price should rise or fall significantly, the position will lose money. That’s because time takes a back seat to the relationship between the strike price and the underlying stock price.

If the stock’s price were to advance sharply (assuming we are using calls to create the calendar spread), the short-term option will rise at a faster rate than the longer-term option. Eventually, the calendar spread will start to lose money.

Ideally, with a calendar spread, you want the underlying stock to remain in a trading range until the near-month option expires. The SPY calendar spread (using the prices I gave first) should be profitable if the stock price remains between US$129 and US$138 until the June expiration. Above or below that range, the position will experience a slight loss, assuming volatility remains unchanged. But, again, the potential loss is limited to the net debit paid.

Generally, you are not likely to lose the entire net debit. As long as the September option has time remaining, it should have some value. Even if the underlying stock’s price drops sharply, volatility would spike — which benefits the longer-term call. IE