Like most trades, options analysis time spreads have a maximum
loss for the buyer. As a buyer, you can only lose what you have
spent. If you paid $1.00 for the options analysis spread then
your maximum potential loss is that $1.00. If you bought the
spread for $2.00, then $2.00 is the maximum potential loss.
The buyer of an options analysis
time spread will be purchasing
the out-month option while selling the nearer month option of
the same strike in a one-to-one ratio. Since the out-month option
will have more time until expiration than the nearer month option,
the out-month option will cost more. This means the buyer will
be putting out money (debit spread), which makes sense. The
buyer can only lose the amount of money they spent to purchase
the options analysis spread. Thus the buyers maximum risk is
the cost of the spread.
The buyer can profit in several ways. First and foremost, being
an options analysis time spread, the buyer can profit by the
passage of time. Options are wasting assets. So as the nearer
month option decays away more quickly than the outer-month option,
the options analysis spread widens (increases in value) and
the buyer sees a profit.
Second, implied volatility can increase. As implied volatility
increases, the out-month option, which the buyer is long, increases
in value more quickly (due to its higher vega) than the nearer
month option, which the buyer is short. This will force the
options analysis spread to widen or increase in value, which
again is profitable for the buyer.
Third, the buyer can make money due to stock price movement.
As stated before, an options analysis time spreads value is
at its maximum when the stock price and the spreads strike price
are identical (at-the-money). You could have an increase in
value if you owned an out-of-the-money or in-the-money time
spread, and the stock moved either up or down toward your strike.
As the stock moves closer to your strike, the options analysis
spread will expand and increase in value creating a profit for
you, the buyer.
The buyers risks are obviously the opposite of the rewards.
You cannot stop or reverse time so the buyer of the options
spread can never be hurt by time.
Implied volatility, however, can decrease as easily as it can
increase. A decrease in implied volatility will decrease the
value of the out-month option (which the buyer is long) faster
than it will decrease the value of the nearer month option (which
the buyer is short) due to the higher vega of the out-month
option. This will narrow the spread thereby creating a loss
for the buyer.
In the same way that stock movement in the right direction can
be profitable for the buyer of an options analysis time spread,
stock movement in the wrong direction can be costly. As the
stock moves away from the spreads strike, the spread decreases
in value. That will create a loss for the buyer of the options