Description
A Time Spread
(A.K.A. - a Calendar
or Horizontal Spread)
involves buying
a Call (or a Put)
with one expiration
and writing the
same strike Call
(Put) with an earlier
expiration.
Risk/Reward
Characteristics
The profitability
of Time Spreads
depends on whether
or not the stock
price is near the
options' strike
price when the near-term
option expires.
It doesn't matter
if it is above or
below the strike
price - the closer,
the better.
Break-even
Point: The spread
has two break-even
points - one some
distance above and
the other some distance
below the spread's
strike price. If
XYZ moves significantly
away from the strike
price, losses will
be incurred.
Time Decay:
At first, the profits
for an ATM Time
Spread are small
as time decay slowly
erodes the short
option. At about
5-6 weeks prior
to expiration, rapid
time decay begins
to affect the near-term
option. ITM and
OTM Time Spreads
gain very little
from time decay,
since there is little
time value to erode
in the short option.
Volatility:
Time Spreads are
sensitive to changes
in the implied volatilities
of their options.
An increase benefits
the spread, while
a decrease hurts
the spread.
Assignment
Risk: As is
the case with all
written options,
the investor must
continuously monitor
the spread for possible
assignment of in-the-money
options prior to
their expiration.
Example
An investor is
bullish on XYZ.
However, that bullishness
is tempered by some
near-term concerns
about either XYZ,
its industry group,
or the overall market
in general.
Thus, because
of these concerns,
the spread must
have both limited
risk and negligible
near-term time decay.
While these concerns
may darken the near-term
prospects, XYZ is
expected to rally
shortly after mid-August.
Therefore, the
investor's opinion
can be summarized
as neutral for the
next 50 or so days,
then bullish!
This Time Spread
reflects the investor's
expectations while
at the same time
taking into consideration
the investor's risk/reward
tolerance level.
First, with regard
to risk, this spread
involves both a
written option as
well as a long option.
Because of the long
option, the written
option is considered
covered. Also, no
matter what happens
to XYZ, the spread's
maximum loss is
limited.
Second, if XYZ
is near $60 in mid-August
time decay will
be positive due
to the near-term
option decaying
faster than the
farther-term option.
Finally, if the
investor's expectations
are correct and
XYZ is near $60
at August's expiration,
the investor will
be left with a position
that is either already
a bullish position
or one that can
be easily converted
into one:
If XYZ is below
$60 at expiration,
the investor will
be long the remaining
60 Call (a bullish
strategy!) for a
price equal to the
initial debit of
the Time Spread
(5 1/8 - 3 1/4).
If, XYZ is just
over $60, the investor
can buy back the
expiring Call and
own the remaining
Call for a price
equal to this closing
debit plus the initial
debit.
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