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Advanced Options Trading - More on Time Spreads

Filed Under Advanced Options Trading 

More on Time Spreads
The Short Time Spread
According to Ron Ianieri, co-founder of the Options University, in situations of high volatility where the straddle might be very expensive, we can look to selling the time spread. We know that with a short time spread we’re short the out month option. That also means we’re short Vega and we’re short volatility sensitivity. If volatility increases and we’re short volatility, we’re going to lose money. Likewise, if volatility decreases and we are short Vega, we’re going to make money. It all depends on where volatility goes.
 
We also know that we don’t want to be short a time spread and have time go by and nothing going on. Why? Well, we’re long the front month option and Theta is decaying extrinsic value like crazy; indeed, we are going to lose money when nothing happens and time passes when we’re short the time spread. We need movement away from the strike for the short time spread to work.
 
To reiterate, if you think a stock is going to move but you aren’t sure of which direction and volatility is so high that you’re straddles and strangles aren’t a good alternative because of price, then you might substitute with a short time spread.
 
Time Spread P & L
The most we can lose in a long time spread is the amount of money we spent to put on the position. At the outset, we have established what the maximum potential loss would be. Because of this fact, we are said to be fully hedged in this position. We know exactly how much we can lose at the absolute very worst scenario.
 
As far as profits are concerned, because of the two different months, things can get complicated. As both options end at different points in time, it means they are more susceptible to a greater amount of different potential variables. For example, for a long time spread at expiration of that front month, whatever your profit or loss is at that point you are now going to be long a naked call and you will be subject to the risks and rewards of that naked long call for as long as you have it on. That adds into the mix of the risk and rewards; in other words, you know your max losses only when both options are still in play. Once the front month expires, the whole situation changes.
 
For the short time spread, the situation is different. The most you can make is what you sold the option for. On the risk side of the equation, if that front month expires then we end up with an out month option; a short naked out month option, and we know we don’t like that. Indeed, there is not enough to gain compared to what could be lost.
 
Because there are two different months involved, when the front month expires we need to take action; the position we’re left with has to be adjusted, closed or moved.
 
For more on all things stock options, go to www.optionsuniversity.com

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