Call Time Spread
Time spreads are also known as Calendar Spreads.
Components
Short one front month call option and long one far month call option. (i.e. the option you sell is to be closer to expiration than the option you are buying).
Risk / Reward
Maximum Loss: Limited on both down and upside for market direction.
Maximum Gain: Limited.
Characteristics
When to use: When you are bearish on volatility and neutral to bearish on market price.
Note that with this payoff graph I have shown the net theoretical result only at the first expiration date when with the underlying trading at 100, which is the best result: the near month call will expire worthless and you will still have a long call ATM position.
Traders use time spreads to take advantage of time decay - the property of options being a decaying asset. However, due to the risk involved in selling naked options, a time spread protects the position buy buying an option in the next month.
The long back month option position offsets large losses that can result from being short options when the underlying market moves unfavourably.
It is best to implement a time spread when there is < 30 days to expiration in the front month. That is for the short side i.e. selling an option with 30 days or less to expiration.
Having said that, not everybody agrees that this is the ideal direction for calendar spreads. David Rivera from Delta Neutral Trading suggests that money can be made by going long the front month option and shorting the back month, provided the front month has a lower "cost per day".
Read more Dave's Cost per Day approach.
Comments (2)
Peter
August 10th, 2009 at 12:34am
Well, I would say in the short term you would be bearish as you're short the near month call option. You want this option to expire worthless, but if the market does rally you have some protection being long the back month call.
Options are more sensitive to underlying changes when the strike is close to the underlying price and the option is close to expiry, so a market rally in the short term would likely hurt your position (depending on the magnitude of the price increase).
I see what you're saying though...looking at the graph, it would appear that the position is more bullish than bearish. But you have to keep in mind that this payoff is taken only at the expiration of the first option...the longer dated option still has some time value left.
Steve
August 8th, 2009 at 6:25pm
I think it is bullish on the market not bearish...isn't it?
Add a Comment