Options Trading Mastery: Construction of the Time Spread

How to trade stock options effectively by constructing a time spread.

Time spreads, also known as calendar spreads, are an ideal way to take advantage of time decay and changes in implied volatility. Time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, it is perfect for when you anticipate stagnant or explosive periods in a stock.

Time spreads, like other spreads, have their own risks and rewards. The risks are very limited for the buyer, but substantial for the seller. The seller's risk can be avoided or contained with due diligence at the expiration of the near month's option. Several strategies can affect the seller's risk. The advantage of the time spread strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.

The construction of the time spread involves the purchase of one option and the sale of another in different months with both having the same strike. You can construct a time spread using either two calls or two puts. A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call, sell the August 45 call or buy April 30 puts, and sell February 30 puts. You can construct a short time spread by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.

The important elements in the construction of the time spread are: using two call or put options on the same stock, using the same strike for both, choosing different months for each and using a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is in a one to one ratio.

Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option's extrinsic value is what decays over time. This is the basis of the time spread's strategy. Since the time spread is built to take advantage of time decay, it is better suited for at-the-money options. This does not mean that you cannot use the time spread with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.

The rate of decay of an in-the-money or out-of-the-money option with one month until expiration is still greater than an in-the-money or out-of-the-money option of the same strike that has three months to go before expiration. This being said, the time spread can be constructed using any option regardless if it is in, out, or at-the-money.

About the author: Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227