Over the course of the next several weeks, I will introduce a new trading strategy each week and execute the strategy in the days that follow. Note that all our options strategies are described in the Guide to Expert Options Trading, which is available on the Cabot Options Trader Pro website.
Today, I introduce a long time spread. This strategy is also often referred to as a Calendar Spread and can be used for calls or puts and be a bullish or bearish trade depending on how it is structured.
A long time spread is used when a stock or index is believed to be range-bound and when volatility is believed to be too low. The strategy is the simultaneous sale of an option in a near-term expiration cycle and the purchase of an option in a longer-term expiration cycle.
As we have discussed in previous educational articles, an option is a decaying asset. As an option nears its expiration, the odds of it finishing in the money diminish. Therefore, options nearing expiration lose value at a significant rate. A long time spread looks to take advantage of the time decay of the option closer to expiration.
The maximum loss for this strategy is the premium paid.
For example, the purchase of the XYZ January/February 100 Long Call Time Spread would entail the sale of the January 100 Call and the purchase of the February 100 Call. The goal of the trade is for the January call to expire worthless while the February call appreciates in value.
With XYZ stock trading at 95, you would simultaneously:
Sell the January 100 Call and
Buy the February 100 Call
For a net debit of $1.
If at the January expiration, stock XYZ was still trading at 95, the January 100 Call that you sold would expire worthless. The February 100 Call would likely have experienced some decay, but at not nearly the rate of the January option. At this point, you would be left with just the February 100 Call.
If at the January expiration, stock XYZ was trading at 90, the January 100 Call that you sold would expire worthless. The February 100 Call would likely have experienced some decay, as well as additional lost value as the stock sold off—reducing the likelihood of this option finishing in-the-money. Thus there is directional risk in this trade.
If at the January expiration, stock XYZ was trading at 99.99, the January 100 Call that you sold would expire worthless. The February 100 Call likely would have appreciated in value significantly as the likelihood of this option finishing in the money has increased. This is the best-case scenario for this trade.
If at the January expiration, stock XYZ was trading at 100 or above, the January 100 Call that you sold will be exercised, leaving you short the underlying stock. The February 100 Call likely would have appreciated in value, though the appreciation is likely to be offset by the loss on the January 100 Call.
Long time spreads can be used with any expiration cycles. For example, we could sell an April call and buy a January 2015 call.