Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.

Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay. There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.

Spreads are more advanced and sophisticated than the strategies discussed in our beginner product “OPTIONS 101.” Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.

When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts – the option you buy and the option you sell.

Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.

It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.

The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.

The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy.

Time spreads are unlike all the other strategies we have discussed before when we talk about rolling or continuing the position. In other strategies, the option component is limited to a single month. At expiration, the position disappears. It either transforms into stock or expires worthless leaving you with no option position. It is different in the case of a time spread because you are dealing with two different expiration months. After the front month expires, in addition to a potential stock position, you will still have an option position – the out-month option will still have time until expiration. To properly roll that position, you must first understand the new position you have inherited.

Let’s look at the call time spread first. For the purposes of our example, let us pretend we are long the September / October 25 call spread. If the stock were to close below $25.00 on expiration Friday of September, the September 25 calls would expire worthless and you would be left with a long October 25 call position. From this position, you would have several things that you could do.

First, you could just sell out the October 25 call. Hopefully, the combination of the expiration of the September 25 calls and their subsequent worthlessness along with the proceeds gained from the sale of the October 25 calls after September expiration might make a profitable trade.

You could keep the position open and continuing in several ways. You could stay long the October 25 call naked. You could sell the October 30 call and become long the October 25 / 30 vertical call spread if you are bullish. You could sell the October 20 call and become short the October 20 / 25 vertical call spread if bearish.

You could buy the October 25 puts and become long the October 25 straddle if you felt the stock would become volatile. You could even sell the stock and create a synthetic put if you were very bearish. There are ways to create a new position that reflects any possible future outlook an investor can have.

If the stock were to close above $25.00, then the September 25 call would close in-the-money. At that time, you would be assigned your short September 25 call and that would translate into a short stock position. That short stock position that you received from the assignment of your short September 25 call along with the remaining October 25 long call position is the equivalent of a synthetic put. At this time, you could close out the position or keep it.

The position is a bearish one so if you felt the stock would be heading down, you could keep the position on. You could sell another option of a different strike to set up either a bull or bear put spread. You could buy the October 25 call to create a long straddle. As you see, there are many different combinations that could be created.

If you were short the September / October 25 call time spread and the stock expired under $25.00 on expiration Friday of September , then you would have a remaining position of a short October 25 call naked. Again, there are many potential ways of continuing the position. Of course, you could always buy back the naked call and close the position if you no longer wanted to maintain a position in the stock.

If you did, you could buy a call in the same month and create a vertical spread, sell the corresponding put and create a short straddle, buy the stock one to 1 and create a buy-write or other combination based upon what you felt the stock would do.

If the stock closed above $25.00 and you were short the call time spread, then you would be left with a long stock position from your long September 25 call and short the October 25 call against the long stock position. The position you would be left with is a buy-write. Depending on your outlook for the stock, you could keep the buy-write on, take it off, or use other options to change the position to what you want it to be.

As far as put spreads, let’s take an example and see where we are when the front month option expires. We will use the September / October 25 put spread for our example.

When long the spread, and the stock closes above $25.00, the September 25 puts, which you are short, will expire worthless leaving you with a long naked put position. From that position, you can close it or combine it with other option or stock to create a different position. Again, there are many different possibilities.

If you were short the put time spread, and the stock closed above $25.00 then the September 25 put, which you are long, will expire worthless leaving you with a short naked put position in the October 25 puts. This position can be closed out or combined with other options or stock to create a strategy that will take advantage of the outlook you have on the stock.

When the stock closes below $25.00, the scenario is different. When long the spread with the stock closing lower than the strike price, the front month put which you are short will be assigned to you thus making you long stock in addition to your long October 25 put. This position is known as a synthetic call.

As before, there are many ways to combine other options and/or stock to change the position so that it is in line with want it to be going forward.

First is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.

Second, the stock can move. As stated before, a time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. So, as long as the stock moves in either direction away from the strike, the seller’s position could be profitable provided that time decay does not outperform the stock movement.

Time, unfortunately, never works in favor of the time-spread seller. The passage of time hurts the seller because the nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value. That obviously produces a loss for the time spread seller. Time can neither be stopped nor turned back. It only moves forward which always hurts the time spread seller.

Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long) due to the out month option’s higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential. For the seller, the maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out- month call. As we know, the out month call will be more sensitive to movements in implied volatility due to a higher vega or volatility sensitivity component. If implied volatility increases then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, he/she will be left short a naked or un-hedged option and a loss on the position. If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured. As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.

The buyer can profit in several ways. First and foremost, being a time spread, the buyer can profit by the passage of time. Options are wasting assets. So as the nearer month option decays away more quickly than the outer-month option, the spread widens (increases in value) and the buyer sees a profit.

Second, implied volatility can increase. As implied volatility increases, the out-month option, which the buyer is long, increases in value more quickly (due to its higher vega) than the nearer month option which the buyer is short. This will force the spread to widen or increase in value, which again is profitable for the buyer.

Third, the buyer can make money due to stock price movement. As stated before, a time spread’s value is at its maximum when the stock price and the spreads strike price are identical (at-the-money). You could have an increase in value if you owned an out-of-the-money or in-the-money time spread, and the stock moved either up or down toward your strike. As the stock moves closer to your strike, the spread will expand and increase in value creating a profit for you, the buyer.

The buyer’s risks are obviously the opposite of the rewards. You can not stop or reverse time so the buyer of the spread can never be hurt by time.

Implied volatility, however, can decrease as easily as it can increase. A decrease in implied volatility will decrease the value of the out-month option (which the buyer is long) faster than it will decrease the value of the nearer month option (which the buyer is short) due to the higher vega of the out-month option. This will narrow the spread thereby creating a loss for the buyer.

Looking at this first adjustment where we moved the June 70’s volatility down to 36 from 40, we have a value of $1.80 at 36 volatility. The August 40 call has a value of $3.00 at 36 volatility. So the spread will be worth $1.20 at 36 volatility.

If you wanted to move the August 70 calls instead, you would take the August 70 call vega of .08 and multiply it by the four tick implied volatility difference.

This gives you a value of $.32 that must be added to the August 70 call’s present value in order to bring it up to an equal volatility (40) with the June 70 call. Adding the $.32 to the August 70 call will give it a $3.32 value at the new volatility level of 40 which is the same volatility level as the June 40 calls.

Now, our spread is worth $1.32 at 40 volatility. August 70 calls at $3.32 minus the June 70 calls at $2.00 gives the price of the spread at 40 volatility.

It does not make any difference which option you move. The point is to establish the same volatility level for both options. Then you are ready to compare apples to apples and options to options for an accurate spread value and volatility level.

Since we now have an equal base volatility, we can calculate the spread’s vega by taking the difference between the two individual option’s vegas. In the example above, the spread’s vega is .03 (.08 - .05). The vega of the spread is calculated by finding the difference between the vega’s of the two individual options because in the time spread, you will be long one option and short the other option.

As volatility moves one tick, you will gain the vega value of one of the options while simultaneously losing the vega value of the other. Thus the spread’s vega must be equal to the difference between the two options vega’s. So, our spread is worth $1.20 at 36 volatility with a .03 vega or $1.32 at 40 volatility with a .03 vega.

Going back to our original spread value of $1.00 with a vega of .03, we can now calculate the volatility of that spread.

We know the spread is worth $1.20 at 36 volatility with a vega of .03. So, we can assume that the spread trading at $1.00 must be trading at a volatility lower than 36.

To find out how much lower we first take the difference between the two spread values which is $.20 ($1.20 at 36 volatility minus $1.00 at ? volatility). Then we divide the $.20 by the spread’s vega of .03 and we get 6.667 volatility ticks. We then subtract 6.667 volatility ticks from 36 volatility and we get 29.33 volatility for the spread trading at $1.00.

We can also determine the volatility of the spread as the spread’s price changes. Let’s fix the spread price at $1.30. To calculate this, we must first take the value of the spread ($1.20 at 36 volatility) and find the dollar difference between it and the new price of the spread ($1.30). The difference is $.10. This dollar difference must now be divided by the vega of the spread. The $.10 difference divided by the .03 vega gives you a value of 3.33 volatility ticks. Then add the 3.33 ticks to the 36 volatility and you get 39.33 as the volatility for the spread trading at $1.30.

Let’s double-check our work by calculating the volatility the other way.

This time we will do the calculation by moving the August 70 calls up to the equal base volatility of the June 70 calls. As calculated earlier, the August 70 calls will have a value of $3.32 at 40 volatility.

The June 70 calls are worth $2.00 at 40 volatility. Thus the spread is worth $1.32 at 40 volatility.

Now let’s again move the spread price to $1.30, $.02 lower than the value of the spread at 40 volatility. As before, we take the difference in the prices of the spread. The result is $.02 ($1.32 - $1.30). Then, divide $.02 by our spread’s vega of .03 (remember that the vega of the spread is equal to the difference between the vega of the two individual options). $.02 divided by .03 gives us a value of .67. That .67 must be subtracted from our base volatility of 40. That gives us a 39.33 (40 - .67) volatility for the spread trading at $1.30. This volatility matches our previous calculation perfectly.

At first glance, you might be wondering why we went through all of these calculations. With the June 70 calls at 40 volatility, price $2.00, vega .05 and the August 70 calls at 36 volatility, price $3.00, vega .08 why not just take an average of the volatility? This would give us a 38 volatility for the spread with a price of $1.00 when in actuality $1.00 in the spread represents a 29.33 volatility.

This would be almost a nine tick difference which represents a whopping 30% mistake! Because, as stated earlier, vega is not linear; you can not weigh each month evenly and just take an average of the two months. For argument’s sake suppose you did. Let’s say you found the difference of the vegas of the options and came up with a spread vega of .03 which is correct. However, when you try to calculate the spread’s volatility and price you would have difficulty.

Since they are weighted differently, you can not simply take the average of the two months and call that the volatility of the spread; it is more complicated than that.

The problem is related to calculating the spread’s volatility with two options in different months. Those different months are usually trading at different implied volatility assumptions. You can not compare apples with oranges nor can you compare two options with different volatility assumptions.

It is important to know how to calculate the actual and accurate volatility of the spread because the current volatility level of the spread is one of the best ways to determine whether the spread is expensive or cheap in relation to the average volatility of the stock.

There are several ways to calculate the average volatility of a stock. There are also ways to determine the average difference between the volatility levels for each given expiration month. Volatility cones and volatility tilts are very useful tools that aid in determining the mean, mode and standard deviations of a stock’s implied volatility levels and the relationship between them.

The present volatility level of the spread can then be compared to those average values and a determination can then be made as to the worthiness of the spread. If you now determine that the spread is trading at a high volatility, you can sell it. If it is trading at a low volatility, you can buy it. But first you must know the current trading volatility of the spread.

In order to accurately calculate volatility levels for pricing and evaluating a time spread, the key is to get both months on an equal footing. You need to have a base volatility that you can apply to both months. For instance, say you are looking at the June / August 70 call spread.

June’s implied volatility is presently at 40 while August’s implied volatility is at 36. You can not calculate the spread’s volatility using these two months as they are. You must either bring June’s implied volatility down to 36 or bring August’s implied volatility up to 40. You may wonder how you can do this.

Actually, you have the tools right in front of you. Use the June vega to decrease the June option’s value to represent 36 volatility or use August’s vega to increase the August option’s value to represent 40 volatility. Both ways work so it doesn’t matter which way you choose.

As you can see, if an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.

Of course, the vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher vega will lose value more quickly than will the nearer month option with its lower vega. In the chart below, you will see how the time spread’s value is affected by decreasing volatility

Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.