Monday, October 24, 2011

An Easy Option Strategy to Consider: Time Spreads

Today, I'd like to share one of the easiest yet most profitable strategies an option trader can make. The option strategy is called a time spread or calendar spread If you employ this strategy successfully, I only ask that you give a healthy portion of your profits to a charity or individual in need!
There are 4 reasons I believe this type of option strategy is worthwhile
1) The trade is easy to construct
2) The trade is easy to manage
3) The trade does not need to be adjusted once opened because it is "forgiving" 
4) The trade is an excellent foundation for more advanced strategies (diagonals/double)
With the above reasons in mind, the first requirement in learning time spreads is knowing how to construct them. The basic time spread is defined in  2 ways:
1) Sell a near month call and Buy a far month call having the same strike or exercise price.
     For instance, you can    Sell a November 50 call to open and
                                                     Buy a December 50 call to open the trade
This is called a call time spread. (bullish bias: believe stock will rise)
2) Sell a near month put and Buy a far month put having the same strike price.
      For instance, you can   Sell a November 50 put to open and
                                                      Buy a December 50 put to open the trade
This is called a put time spread. (bearish bias: believe stock will decline)
Either time spread is opened as a single trade.
Making the Trade:
Questions you ask yourself:
1) What underlying stock do I choose for my option time spread?
2) Once I've chosen a stock, am I bullish, bearish, or neutral on its price direction?
3) Once I've determined the direction, I then ask what option months and strike price do I choose?
4) What is my maximum risk/reward in placing the trade?
To answer these questions, let's look at an example.
Answer #1: An underlying stock that I've chosen is Lockheed Martin Corporation (LMT).  Currently, Lockheed's stock price is trading at $77.40 per share.  Lockheed, as well as most of the stock market has seen a recent rally.  However, I am of the belief that Lockheed has limited upside over the next couple of months, and do not anticipate a collapse anytime soon either.  Answer #2: So, my stance is more neutral than anything.  Given my neutral bias, I will place a put time spread trade.
Answer #3: Now I need to determine Lockheed's put option months and strike price.  October put options have already expired, so I will use the November (near month put contract with 27 days till expiration) and December (far month put contract with 55 days till expiration).  In choosing what put strikes to use, as a rule of thumb, always opt for the out-of-the-money (OTM) strikes because in-the-money (ITM) strikes exhibit larger bid ask spreads plus they run a higher risk of early assignment.  In Lockheed's case, the best OTM put strike is 75.  The 75 strike price is currently $2.40 OTM ($77.40-75).  See the LMT option chain.
With these three questions answered, we can now construct the specific put time spread trade in Lockheed Martin and then answer question 4:
Note that we are trading 5 contracts that results in a net debit of $0.98 per contract.  Time spread options always results in a net debit or payment.  $0.98 is the midpoint price difference between the December 75 option buy (ask -paid) premium price and November 75 option sell (bid -received).  So the initial total cash outlay is approximately $500.00 including trading costs.  Answer #4: The maximum gain you can obtain is approximately $678.00 if LMT trades at exactly $75 at the end of November expiration.  Obviously, the probability of that happening to the penny is not likely.  However, if you look at the profitability link, you can see that you will make money on the trade as long as LMT trades between a break even low of $71.28 and break even high of $78.58.  You begin to lose money on the trade if it breaks below or above those levels.  Should LMT explode up or plunge down, you can always exit your trade before incurring the maximum loss.  Keep in mind that the maximum loss of ~$480 doesn't occur until the stock price goes to $20 or as high as $90.00.  See profitability analysis:
Let me know if you have any questions.  Blessings to all!
Follow me on Twitter @ H2Options
The above example was for illustrative purposes only.  Option trading involves risk and you can lose money!
Follow H2Options on Twitter