Time spreads can be a profitable investment strategy if you
understand the concept of time decay.
A time spread is designed to take advantage of the fact that an
option’s decay curve is non-linear; that is, an option’s value
does not decay evenly over time. As an option gets closer to
expiration, its rate of decay increases meaning the option loses
value more quickly. That decay rate increases progressively day
after day until expiration.
An option’s decay rate begins to accelerate when the option is
about 45 days out. It picks up steam at 30 days out and really
comes under decay pressure at about 15 days out. This scenario
can be likened to a boulder rolling down from the top of a hill.
As it starts, it rolls slowly and then gains more and more speed
and momentum the further it gets down the hill until it achieves
its maximum speed at the bottom.
Option decay acts the same way- gathering speed and momentum as
the option approaches expiration. In time spreads, both options
have the same strike price that remains constant.
However, each option’s value decays at different rates and over
different lengths of time. The option with one month until
expiration experiences value decay at a faster rate than the
value of an option that has three months until expiration.
If you buy an option with three months to go and sell an option
with the same strike but with one month to go you have set up a
spread between the two options values (prices). As time passes,
your short option loses value more quickly than your long option
that decays more slowly. The value of the spread widens and you
profit from that spread’s expansion. This is the fundamental
behavior of the time-spread.
The above chart shows an option decay graph. The numbers across
the bottom represent days to expiration. Along the decay line,
you will notice an “X” at the 30 day to expiration line and
another “X” at the 60 day to expiration line. The first “X”
represents a 30 day option while the second “X” represents a 60
day option. If you look closely at this chart you will see the
nature of the time spread.
Let’s say you are long the 60-30 day time spread. That means you
are long the 60 day option and short the 30 day option. Further,
we will assign a price of $3.00 to the 60 day option and $2.00
to the 30 day option. Since you pay for the one and receive
payment for the other the bottom line cost of what you put out
for the spread is $1.00.
Now, look at the slope of the line (representing decay) drawn
from the 60 day option to the 30 day option. Compare the slope
of that line to the slope of the line drawn from the 30 day
option to expiration (Day 0). As you can see, there is a big
difference in the steepness of the slope of the two lines. The
slope of the line drawn between the 30 day option to expiration
is much steeper than the slope of the line drawn from the 60 day
option to the 30 day option.
These slopes show how the time spread works! During the first 30
day period of time, the 30 day option has a steeper slope,
meaning a higher rate of decay. During that 30 day period, this
option will go from $2.00 to $0. Meanwhile, the 60 day option,
having a flatter slope will not decay as quickly.
During the same 30 day period, it goes from $3.00 to $2.00.
Remember, the spread’s bottom line cost was $1.00. The 30 day
option (now expired) will be worth $0 while the 60 day option
(now 30 day option) will be worth $2.00. If you had invested in
this spread, after 30 days decay you would be holding one option
worth $2.00. The investment has provided a nice return!
However, this is an ideal situation. The stock price and
volatility remain constant and you capture the decay. The time
spread has worked just as it should and it does work that way
sometimes. But, nothing works as it should all the time. As we
know, stock prices and volatility levels do not remind constant.
They are always changing. In the time spread strategy the
investor must choose opportunities carefully. In addition to
picking a stock that will be in a stagnant period, the investor
should look for two other situations where the spread has profit
possibilities: changes in volatility and to a lesser degree
stock price movements.
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