The seller of a time spread buys the nearer month option and
sells the outer-month option in a one to one ratio.
In order to profit from trading futures and options
, the seller
is looking basically for two things.
First is a decrease in implied volatility in trading futures
and options. As volatility decreases, the out-month option (which
the seller is short) loses money faster than the near month
trading futures and options (which the seller is long) because
of the higher vega in the out month option. This will cause
the trading futures and options spread to contract or lose value.
That will be profitable for the time spread seller.
Second, the stock gained from trading futures and options can
move. As stated before, a trading futures and options time spread
is at its widest, most expensive point when it is at-the-money.
A movement away from the strike in either direction decreases
the value of the trading futures and options spread. So, as
long as the stock moves in either direction away from the strike,
the sellers position could be profitable provided that time
decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread
seller. The passage of time hurts the seller because the nearer
month option (which the seller is long) naturally decays at
a faster rate than does the out-month option (which the seller
is short). These differing decay rates cause the trading futures
and options spread to expand and increase in value. That obviously
produces a loss for the time spread seller. Time can neither
be stopped nor turned back. It only moves forward which always
hurts the time spread seller.
Increases in implied volatility are also detrimental to the
potential profits from trading futures and options. When implied
volatility increases, the out month option (which the seller
is short) increases in value faster than the near month option
(which the seller is long) due to the out month options higher
vega. This creates an expansion in the trading futures and options
spread and increase its value resulting in a negative for the
The seller, in theory, has an unlimited loss potential. For
the seller, the maximum loss potential is not so much determined
by the trading futures and options price movement but by the
movement in implied volatility. As the seller, you will be long
the front month call and short the out month call. As we know,
the out month call will be more sensitive to movements in implied
volatility due to a higher vega or volatility sensitivity component.
If implied volatility increases then the sellers short, out
month option will increase more in value than will the sellers
long, front month option. This will cause the trading futures
and options spread to widen or increase in value; that is negative
for the seller.
The second risk to is that the option the seller is long is
going to expire approximately 30 days prior to the option the
seller is short. If volatility does not decrease or the stock
from trading futures and options does not move away from the
strike significantly before the sellers long option expires,
he/she will be left short a naked or un-hedged option and a
loss on the position. If the seller can wait out the position,
the lost extrinsic value from trading futures and options can
be recaptured. As we know, this option too has a limited life
and must shed its extrinsic value, no matter how much, by its
expiration. The problem facing the seller is that the position
is no longer hedged and the seller now faces unlimited risk
in trading futures and options
Once the long option expires and the seller is left short a
now naked call, stock price movement in the wrong direction
is a substantial risk and under the circumstances described
above, a big problem. While the seller can wait out an implied
volatility movement that created an increase in extrinsic value,
they probably will not be able to wait out a large, negative
stock movement creating an increase in intrinsic value. In that
case the seller must take action to prevent substantial losses
once the front month expires. Attention to the implied volatility
in the farther out option when the nearer month option expires
can save the seller from a large loss.