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Pricing Time Spreads Options Trading Strategy

Filed Under Advanced Options Trading 

Pricing Time Spreads
 
Remember, when trading time spreads (aka:calendar spreads) we’re not really trading strikes, we’re trading time and the time value between one option month to another option month. Both options must be equally reflected in the difference between one month to the other-regardless if we’re using calls or puts. The difference in time between a May $25 call and a June $25 call is the exact same difference in value as the difference in time between the May $25 put and the June $25 put. They are the same; buying the call time spread is the same thing as buying the put time spread.
 
If this is so, that means when we look at a call spread we can look at the corresponding put spread and know that the two are supposed to be equal. But according to the Options University, before we buy the call time spread we might want to look at the put time spread. If we’re going to buy a spread, we want to buy the cheaper one if they are both going to do the same thing.
 
A call spread will normally trade higher than its corresponding put spread by the amount of interest minus dividend. If there is no dividend, the call spread should trade higher than it’s corresponding put spread by the amount of interest.
 
The following is an example taken from the Options Mastery Course put out by the Options University. Suppose we’re looking at the May $25-June $25 (could be a call or put) and we’re saying that if the May-June $25 call spread is trading for $1.30 and the put spread is trading for $1.25. In this example, there is no dividend. To see it the rule holds true, we need to know what the interest between May and June is. Let’s say the interest between May and June is 10 cents. The rule is telling us that this call spread should be trading 10 cents higher than the put spread- but it’s not. 
 
The call spread is only trading 5 cents higher. It should be trading 10 cents higher. That means the call spread is slightly under valued versus its corresponding put spread. Remember this is for corresponding options. In this scenario, we would rather buy the June $25-May $25 call spread at $1.30 than we would want to buy the May $25-June $25 put spread at $1.25 even though it has a higher price. However, in reality the call is 5 cents under priced.
                       
Now, things get interesting. In this example, we would buy the call spread and when it was time to get out or if we are a seller of the spread instead of a buyer of the spread, we would sell the put spread. Why? Because the call spread should trade higher than the put spread by the amount of interest minus dividend. With no dividend then the call spread should trade higher than the put spread by 10 cents. Right now it’s not. That means the call spread is under valued.
 
If the call spread were trading for $1.40 instead of $1.30 things are different.
If the interest is the same at 10 cents and there is no dividend, the call spread is trading higher than the 10 cents and is thus over valued.  If we are going to buy a time spread, we want to buy the corresponding put spread at $1.25 because in theory it’s like buying the call spread for $1.35 because the call spread is always supposed to be 10 cents higher.
 
Four times a year, on dividend paying stocks, we might have the put spread actually trading higher than the call spread. For example, what if there’s a 25 cent dividend? Then the call spread should be trading higher than the put spread by 10 cents minus 25 cents.
 
In Summary, if one spread is more expensive than the other, and we’re a buyer, we want to get in the cheaper one. As a seller, we want to obviously sell the more expensive one
 
For information on all things stock option, go to www.optionsuniversity.com

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