Selling a short-term put and buying a long-term put with the same strike price make up a long calendar spread with puts, also referred to as a time spread. The idea is that the longer-term put retains the majority of its value while the shorter-term put loses value more quickly as expiration draws near and, ideally, is worth nothing or almost nothing at expiration. This lowers the cost of the trade by selling the shorter-term put.
At the shorter-term put’s expiration, the trader wants the stock to trade as low as the strike price, but not lower. When this option expires worthless, there will only be one remaining long put, which will allow for profits if the stock price keeps falling.
Profit/Loss
The profit potential for this position is limitless, at least until the stock price drops to zero, but not until the shorter-term put expires worthless.
The time value of this spread becomes worthless if the stock makes a significant move in either direction before the short-term put expires, and the trader will forfeit the premium they paid to enter the trade.
Breakeven
The stock must make a significant move either higher or lower before the short-term put expires for the long calendar spread with puts to reach either of its two breakeven points. It is impossible to pinpoint these points, however, because the time value of this trade depends on the volatility level.
Example
If the stock XYZ is currently trading at Rs105 and we decide to purchase a long calendar put spread with a strike price of Rs100 that entails selling a March call for Rs3 and buying a July call for Rs4.50, our subsequent cost would be Rs1.50 (Rs4.50-Rs3).
The March puts would expire worthless and be removed from our account if the stock traded at Rs101 at the time of expiration in March. Only the lengthy July puts remain at this time. We would make Rs10 on the puts if the stock fell to Rs90 by the July expiration, but since we paid Rs1.50 for the position, our profit would only be Rs8.50. Consider that our profit would have been only Rs5.50 if we had only purchased the July puts at the beginning (rather than selling the March).
The shorter-term puts would expire worthless if the stock reached Rs120 by March expiration, but the longer-term July puts would be so far out of the money that they would have almost no value left. The investor could either hope for a miracle or sell out of the positions for pennies. The longer-term puts would also expire worthless if the stock doesn’t reach Rs100, and the investor would lose his Rs1.50 investment.
Both sets of puts would be so far in the money by the time March expiration rolled around that they would effectively have the same value, made up entirely of intrinsic value. The Rs1.50 that was paid for the job would therefore be lost.
Conclusion
If you anticipate a stock to trade lower, but that move will occur in the future after the short-term puts have expired, you should execute a long calendar spread with puts.
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