Time Spreads - Definition
An options trading strategy that uses a combination of options with different expiration dates in order to profit primarily from time decay.
Time Spreads - Introduction
Time Spreads, also known as Calendar Spreads, is a group of options trading strategies that seek to profit from a difference in time decay between short and long term options. Time spreads are so named due to the fact that they increase in profit as time goes by. Time Spreads have been gaining popularity recently as a way of profiting from time decay in the short term while keeping the possibility of profiting from explosive directional moves in the long term. This tutorial shall cover what Time Spreads are, the nature and role of Time Spreads as well as the different categories of Time Spreads and a detailed listing of all Time Spreads. Time Spreads referred to here are long Time Spreads.
What Are Time Spreads?
Time Spreads are options trading strategies that profit primarily through the difference in rate of
time decay between longer term options and shorter term options. Due to this nature, Time Spreads are typically
neutral options strategies on a month to month basis as the main source of profit for Time Spreads is the decay of
extrinsic value of the short term options. Time Spreads typically suffers if the underlying stock stages a breakout which causes the short term options to rise in value faster than the long term options. However, the advantage that Time Spreads have against other neutral options strategies is that it keeps a long term options position in place which can be eventually positioned to take advantage of a longer term directional move. In general, any options trading strategies that put together options of different expiration months are Time Spreads.
Why Use Time Spreads?
Why do some options traders use Time Spreads instead of just straight forward
naked call writes or
naked put writes? In fact, a Short Straddle would be ideal in options trading if a stock is expected to remain stagnant in order to profit from time decay. Why Time Spreads?
There are 3 main reasons why some options traders use Time Spreads:
1. Lower or No Margin Requirement
The long term options in a typical Time Spread provides an offset against the short term writes which results in lower or no margin needed to put on the position. Naked writes requires extremely high margin and locks up a large chunk of the funds in your account.
2. Limited Risk
All naked write options trading strategies expose you to unlimited risk, losing money as long as the stock moves against you. However, due to having an offsetting long position in a Time Spread, Time Spreads have limited risk exposure, putting a cap on the maximum loss that can result on the position.
By closing out the short term options, Time Spreads can instantly tranform into long directional or volatile positions, taking advantage of strong directional moves.
Working Mechanics of Time Spreads
Time Spreads work due to the fact that options with longer expiration has lower theta than options with shorter expiration. In options trading, Theta is the options greek that governs the rate of time decay of options. The higher the theta, the higher the rate of theta. Naturally, when you are short an options position, you would want a higher theta so that time decay would reduce the value of the contract, resulting in a profit in your account. When you are long an options position, you would want a lower theta so that time decay won't reduce the value of the contract so quickly. As such, time spreads need short term options to have a significantly higher theta than the long term options in order to return a profit.
The picture below is a comparison of real theta values of options on the QQQQ on 21 October 2009.
The picture above shows the June 2010 and November 2009 call options on the QQQQ across 3 strike prices. From the picture above, theta values of the QQQQ November 2009 call options are more than twice the theta value of the June 2010 options, ensuring that the short term options decay twice as fast as the long term options in order to return a positive return.
Time Spreads also benefit from a rise in implied volatility.
From the picture above, the Vega value of the QQQQ June 2010 options is a lot higher than the vega value of the November 2009 options. In options trading, Vega is the options greek that governs how much the value of an option react to changes in implied volatility. Options with higher vega would rise in value faster than options with lower vega when implied volatility increases. As such, when implied volatility of the underlying stock rises, the long positions in a time spread would increase in value faster than the short positions, returning a positive return.
Types of Time Spreads
In Options Trading, Time Spreads can be broadly classified as Horizontal Time Spreads or Diagonal Time Spreads. According to the way the options involved are lined up across an options chain.
Horizontal Time Spreads are the most common form of Time Spread where you buy a long term call or put option and then write a near term call or put option at the same strike price.
As you can see from the picture above, horizontal Time Spreads are so named due to the way the options involved are lined up horizontally across an options chain.
Diagonal Time Spreads are Time Spreads whereby options of different strike prices are used as well.
As you can see from the picture above, diagonal Time Spreads are so named in options trading due to the way the options involved are lined up diagonally across an options chain.
List of Time Spreads
Horizontal Time Spreads
Call Time Spread : Time Spread using only call options on the same strike price.
Put Time Spread : Time Spread using only Put options on the same strike price.
Calendar Straddle : Time Spread using BOTH Call and Put options on the same strike price.
Calendar Strangle : Time Spread using BOTH Call and Put options on the different strike prices.
Diagonal Time Spreads
Call Diagonal Time Spread : Time Spread using only call options on different strike prices.
Put Diagonal Time Spread : Time Spread using only put options on different strike prices.
Advantages Of Time Spreads
Little or no margin required
Versatility to transform position into a long position.
Disadvantages Of Time Spreads
Lower profitability than a straight forward naked write.
Questions About Time Spreads
"How To Erase Margin Requirement In a Time Spread?"