Option Trading Strategies: The Directional Time Spread

Many traders think of calendar spreads (or time spreads) as “theta plays,” or strategies benefiting from the passage of time. This idea is an oversimplification at best. Time spreads are complex option trading strategies involving several independent influences on an option's price including time, implied volatility, and direction.

While these spreads have a lot going on, the ultimate success or failure of time spreads is a function of the relationship of the underlying stock price to the strike price at the expiration of the short-term option. Time spreads are trading strategies that can offer an interesting alternative to a more traditional directional play.  Let's look at an example of one of these relatively advanced option trading strategies. Note that the tickers used are for the purpose of illustration only and do not constitute trading recommendations.  Prices are hypothetical.

Dave is bullish on Baidu.com BIDU, which is trading at $120 per share. Dave is looking for a lower risk, higher leverage way to position himself for a rise in BIDU to around $130 over the next two months. This trade goal might be achieved with a directional time spread. Dave makes the following trade:

• Buy 10 April/June 130 call time spreads for $4.60

Dave sold the April 130 calls for $2.40 and bought the June 130 calls for $7.00 for a net debit of $4.60, or $4,600 for 10 contracts. His objective is to see the value of this spread grow to a multiple of his investment. To understand how this spread might grow in value over time, it's important to understand how time ties into the relationship of the stock price versus the strike price for option trading strategies.

At this point, with BIDU trading at $120, both calls are out-of-the-money. But if BIDU stock rises, the value of these calls will each increase in value. Time, however, is interwoven with stock price in the success or failure of the trade. As time passes, each of these options will incrementally lose some of their time value with each passing day.

The rate of the option premium's decay, theta, can be (and usually will be) disparate between the two options. Shorter-term, near-the-money options have higher thetas than their longer-term counterparts.  Therefore, as time passes, the April calls will decline in value faster than the June calls.  This makes some logical sense as one day is a greater percentage of the life of the April option than that of the June option.  At the time of this trade, theta for the April 130 call was 8.3; theta for the June 130 call was 7.1.

The ideal outcome is for the June 130 calls to gain in value as much as possible while the April 130 calls expire worthless. The best-case scenario at April expiration is for BIDU to be trading exactly at the shared strike price of 130 when the shorter-term option expires. The chart below from our Profit/Loss calculator tool shows a profit-and-loss diagram of Dave's spread at April expiration (on April 15).  You can access this tool and others through a virtual trading account.

 

In this diagram, the points plotted are more of a guide than a clear-cut representation. At April expiration, the value of the April-call component of this spread will be determined by the relationship of the stock to the strike. The June option's value will be valued at the then-market level, which is undeterminable today.  That makes it difficult to plot exact price points.

If BIDU stock declines far enough, both the April and the June options can become worthless, leading to a loss of the entire net premium spent on the spread. If BIDU falls far enough, Dave could lose $4,600.

If Dave is right, however, and BIDU is trading right at $130 when the April option expires, he could reap a windfall profit. In this scenario, the April calls expire and he keeps the initial credit of $2.40 – $240 per leg, $2,400 for the 10 lot — on the short leg. He'll also possibly gain in the long June calls from the directional movement.

For this and various other option trading strategies, Dave's at risk if the stock rises too much. If BIDU is above $130 at expiration, the April calls will get assigned. The June calls continue to rise in value, but the gains are more than offset by the short stock created by the assignment of the short call.

Although losses can be incurred if the stock price rises dramatically, they are ultimately limited to the initial premium paid as well. As the June 130 calls become deep in-the-money, they begin to change in value more like long stock. Gains on the long June calls and losses on the short stock will move in step. The maximum loss will likely be less than $4,600 per spread as long as the June calls trade above their intrinsic value.

If the April option expires without assignment, gains are theoretically unlimited if the stock rallies while losses are capped at the premium paid for the June call, or $7.00 per contract ($7,000 for a 10-lot).  Breakeven for the June call would be $137.00, or the strike price plus the premium paid.

Photo Credit: Joe Lanman

The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.

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