Butterfly Option Strategy » Stock Trading1

Options Mastery Lesson: Straddles

admin — Tue, 26 Jan 2010 02:16:44 +0000

In our previous reports, we discussed option strategies that feature the use of options in combination with stock such as the buy-write and the use of options against each other in the form of spreads. We will focus on the Straddle, which uses options in unison with each other.
Unlike a spread that features a long option versus a short option, the Straddle features one position (either long or short) and two options – a call and its corresponding put. A Straddle is the strategy composed of a long (or short) call and a long (or short) put where both options have the identical strike price and expiration month.
When putting together a Straddle, the construction should be as follows:
-Different options (call and its corresponding put)
-Same stock
-Same strike
-Same expiration
-One-to-one ratio
Straddle positions are referred to as ‘long Straddle’ or ’short Straddle’ depending on whether you purchase the call and its corresponding put (long) or sell the call and its corresponding put (short). For example, we will construct the long Straddle by purchasing both the July 60 call and the July 60 put. We will construct the short Straddle by selling both the July 60 call and the July 60 put. It is important to note that the Straddle is a one-to-one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one corresponding put.
Straddle Scenarios
The Straddle relies on movements in stock price or in implied volatility to establish profit opportunities. The Straddle buyer looks for the stock to move aggressively in either direction or for the anticipated perception of possible aggressive moves that will bring about an increase in implied volatility.
Sellers of the Straddle hope for the opposite scenario. A lack of stock movement or a perceived lack of movement, causing implied volatility to decrease, will create profitable scenario.
Straddle Mechanics
Let’s look at how a Straddle works. In our illustration, we see the July 65 Straddle. We can either buy or sell the Straddle. If we purchase both the July 65 call and the July 65 put simultaneously in a one-to-one ratio we have a long Straddle. To construct a short Straddle we would sell both the July 65 call and July 65 put simultaneously in a one-to-one ratio.
Continuing with our illustration, we will set the price for each of the options. With our imaginary stock trading at $65.50, the July 65 call trades at $3.13 and the July 65 put trades at $2.47. The combination of these two prices accounts for the $5.60 cost of the Straddle. Fast forward to expiration and observe what happens to the value of the Straddle at different stock prices.
Price Call Put Straddle P & L
50 0.00 15.00 15.00 9.40
55 0.00 10.00 10.00 4.40
60 0.00 5.00 5.00 -.60
65 0.00 0.00 0.00 -5.60
70 5.00 0.00 5.00 -.60
75 10.00 0.00 10.00 4.40
80 15.00 0.00 15.00 9.40
As you can see, the Straddle’s value increases the further the stock moves away from the strike. The closer the stock is to the strike, the lower the value of the Straddle at expiration. The chart clearly shows that the more the stock moves away from the strike, the higher the Straddle’s value becomes. Conversely, the closer the stock finishes to the strike, the lower the value of the Straddle. Owners of Straddles want and need movement while sellers of Straddles want and need stagnation.
How does this example influence your investment strategy? If you feel that a stock is likely to move aggressively in either direction or if you feel that implied volatility is likely to increase, possibly due to impending news (such as earnings, FDA approval, etc.), look into the purchase of a Straddle. If you feel a stock is likely to enter a stagnant phase, or if you feel that implied volatility is likely to decrease, the sale of a Straddle can be a very profitable trade for you.

Options Trading Mastery: Rolling the Position

admin — Sun, 24 Jan 2010 02:13:26 +0000

The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.
If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.
If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.
As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.
We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

Options Trading Lesson: Closing the Time Spread Position

admin — Sat, 23 Jan 2010 03:20:18 +0000

It is important to remember that the time spread will leave you with several potential positions that can be altered by other options or stock in numerous ways.
There are a number of decisions you must make to clarify your understanding and goals. Being open to a number decisions can be a very good thing for the flexibility of your position, whether entering or exiting trades. In this example we’ll look at the position you have and the ways you can make your decisions.
First, it is important to understand what position you are going to be left with when the near-month option expires.
Second, you must form your opinion of what you think the stock is going to do (formulate a bullish or bearish lean) and then figure out the best way to take advantage of that opinion.
Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.
It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.
Concluding Thoughts
The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.
The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy. Don’t take this too lightly.
The residual position does allow you many choices including closing out the position totally, or continuing the position by combining it with either stock or another option to create a new position that fits the investor’s new expectations for the stock.

Options Trading Mastery: Behavior of the Time Spread

admin — Tue, 19 Jan 2010 14:58:26 +0000

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 options 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 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 is similar to a boulder rolling down from a hilltop. As it starts, it rolls slowly, then gains 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. 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 one with 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.
Consider that you are long the 60-30 day time spread. That means you are long the 60-day option and short the 30-day option. 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.
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 a 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!
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. 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 remain 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.

Options Trading Mastery: Understanding Spread Prices

admin — Tue, 19 Jan 2010 01:59:15 +0000

During the life of a vertical call spread, the spread will trade between its minimum and maximum values (between 0 and the difference between the two strikes). In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.
Starting from a stock price of 37.5, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.5 dollars. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them. Thus, in the spread, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50 the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.
A general rule of thumb is: if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.
For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spreads value will increase toward its maximum value described by the difference between the two strikes.
For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.

Options Trading: Intrinsic Value and the Vertical Spread

admin — Mon, 18 Jan 2010 14:30:06 +0000

An investor must always keep in mind that vertical spreads have an intrinsic value. This means it is possible to consider them ‘in the money.’ If a vertical spread has an intrinsic value, it can also have an extrinsic value. Unlike maximum intrinsic values that equal the difference between the strikes at expiration, maximum extrinsic value deviates from spread to spread based on several factors.
During a vertical spread’s life, its price will fluctuate between zero and the value of the difference between the two strikes. An investor can determine the price of the spread, at any given time, by the location of the stock and the time until expiration.
At expiration, what remains for the two options is the intrinsic value of each. Therefore, the value of the spread is the difference between each option’s intrinsic values at expiration.
Because vertical spreads have an intrinsic value, the term ‘moneyness’ applies to them. Moneyness refers to whether or not and by how much an option, or a vertical spread, may be in the money or out of the money. This is a term used mostly by floor traders, but is still worth noting here.
Vertical Call Spread and Vertical Put Spread Value
Spreads with intrinsic value are considered in the money. How can you identify the value of a vertical call spread or a vertical put spread? Compare the stock price to the strike prices.
Look at any vertical call spread. If the stock price is above the lower strike of the spread, the spread is in the money. In the Feb. 50 – 55-call spread, if the stock is trading at $52.00, then the spread would be in the money by $2. This is because if the spread expired today, the Feb. 50 calls would finish $2.00 in the money. The Feb. 55 calls would finish worthless because they are out of the money. The spread, however, would be in the money with a value of $2.00.
The rule is similar for determining whether or not a spread is out of the money. If the stock price is lower than the lower strike of the spread, the spread is out of the money. Again, looking at the Feb. 50 – 55 call spread, if the spread expired today and the stock price closed at $48.00, (lower than the lower strike) then the spread would be out of the money, thus the spread will be out of the money. If the stock is trading at the same price as the lower strike price, the spread is considered at the money.
For vertical put spreads, a spread is determined to be in the money if the stock price is lower than the higher of the two strikes of the spread. For example, look at the Sept. 40 – 45 put spread. If the stock closes at $42.00 on expiration day, the Feb. 45 put would end up in the money and worth $3.00. The Feb 40 puts would be out of the money creating a $3.00 intrinsic value for the spread. Since the spread has an intrinsic value, it is in the money.
A vertical put spread is out of the money if the stock price is higher than the higher strike of the spread. So, going back to our Sept. 40 – 45 put spread example, if the stock was to close at a price of $46.00 (higher than the higher strike) then both the Sept. 40 and 45 put will expire worthless. Thus the spread will be worthless and out of the money.
A vertical put spread is considered at-the-money when the stock price is equal to the higher strike price.

Options Trading Mastery: Spread Prices

admin — Sun, 17 Jan 2010 14:08:59 +0000

Vertical spreads will trade between its minimum and maximum values – zero and the difference between the two strikes. In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.
Remember, this maximum gain occurs at expiration. Before that, the spread will trade with a premium.
Starting from a stock price of 37.5, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.50. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them.
Thus, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50, the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.
A general rule of thumb is if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.
For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spread’s value will increase toward its maximum value described by the difference between the two strikes.
For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.
Factors that Affect Spread Pricing
The determination of pricing as described above works in most cases. Be aware that it assumes that the implied volatility in both the 35 and 40 calls is the same. Most often, these two options will have a slightly different implied volatility.
This intra-month difference in implied volatility values through different strikes is known as a vertical volatility skew. The reason the markets run volatility skews is to make sure that out of the money options have enough premium in them to justify the individual option’s risk/reward scenario.
Whatever factors affect the vertical spread, they are contingent on where the stock is in relation to the spread. Changes in implied volatility affect the price of a spread as stated above but the position of the stock in relation to the strikes of the spread is a key determinate of price.

Options Trading Lessons: Vertical Spreads

admin — Sun, 17 Jan 2010 02:56:37 +0000

There are two main types of vertical spreads. There is the vertical call spread and the vertical put spread. Each spread allows you to do two things. First, you can buy it, making you long the vertical spread. Second, you can sell it making you short the vertical spread. Both can be employed to take advantage of directional stock plays. When we use the term ‘directional stock play,’ we refer to using vertical spreads to capitalize on anticipated stock movements either up or down.
A bull spread is used when the investor feels that a stock is most likely to go up. As we recall, ‘bullish’ means to have a positive outlook on a stock’s future movement. There are two ways to set up a bull spread. The first is with the use of calls. In this case, a bullish investor would buy a vertical call spread (bull call spread). This is accomplished by buying a call with a lower strike price and selling a call with a higher strike price.
The second way to construct a bull spread is with the use of puts. A bullish investor could sell a vertical put spread (bull put spread) hoping to profit from an increase in the stock’s value. The investor would sell a put with a higher strike price and buy a put with a lower strike price. Let’s take a look at how the P&L chart of a Bull Spread looks below.
To recap, if you feel a stock will be increasing in value, you may put on a bull spread by either buying a vertical call spread (bull call spread) or selling a vertical put spread (bull put spread)
A bear spread, however, is used when, you the investor, feels a stock is likely to trade down. Remember, ‘bearish’ means that one’s outlook on the future movement of the stock is negative. To take advantage of this expected downward movement, the investor would put on a bear spread. This can be done in either of two ways.
First, the investor can do it using puts. The purchase of a vertical put spread (bear put spread) can be accomplished by purchasing a put with a higher priced strike and selling a put with a lower priced strike.
The second way an investor can construct a bear spread is by using calls, specifically, by selling a vertical call spread (bear call spread). You do this by selling a call with a lower strike price and purchasing a call with a higher strike price.
So if you think that a stock is likely to decrease in value, you sell a vertical call spread (bear call spread) or purchase a vertical put spread (bear put spread). Let’s take a look at the P&L diagram for a Bear Spread below.
Finally, there are two fundamentals that are universal to all vertical spreads. These fundamentals are critical to understanding the foundation of the vertical spread strategy: (1) you can determine a vertical spread’s maximum value by taking note of the difference between the two strikes and (2) vertical spreads have intrinsic value.

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Sat, 16 Jan 2010 14:16:13 +0000

Construction of a vertical spread occurs with the purchase and sale of a call (put) in the same stock and in the same month. The only difference between the two options is the strike price. For example, an investor would construct a vertical spread by purchasing the IBM June 55-call while selling the June IBM 60 call. This trade would be called the IBM June 55 – 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45 – 60 put spread.
The key to the constructing these vertical spreads is choosing options in the same stock and month, but different strikes and in a 1 to 1 ratio. That is, you must purchase one option for every one you sell or sell one option for every one you buy.
Value and the Vertical Spread
A vertical spread’s maximum value is the difference between the two strikes. For example, the maximum value of the June 55 60-call spread mentioned previously is $5.00. [60 - 55] = $5.
Spread- Difference in Strikes – Spread Maximum Value
August 35 – 40 call 5 $5.00
April 70 – 85 put 15 $15.00
Nov. 20 – 22.5 call 2.5 $2.50
Dec. 40 – 50 put 10 $10.00
Jan 60 – 80 call 20 $20.00
Using the June 55 – 60-call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the options will be worth parity, as all of the extrinsic value will have eroded away.
Where does the spread get its value? From its two components – the call (put) you buy or the call (put) you sell. Look at the spread’s value with a couple of different closing stock prices. If the stock closes at $55, then both the 55 strike and the 60 strike will be out of the money and worthless. The value of the spread will be zero since both options are worth $0. If the stock closes at $57.50, the June 55 calls will be worth $2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth $2.50 (June 55 call $ 2.50 – June 60 call $0).
If the stock closes at $60.00, then the June 55 calls will be worth $5.00. Meanwhile, the June 60 calls will be worth $0. This means that the spread will be worth $5.00 (June 55 call $ 5.00 – June 60 call $0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.
As the stock goes higher, the June 60 call becomes in-the-money and gains intrinsic value. For every penny that the stock increases in value, the June 55 calls and June 60 calls gain value equally, keeping the $5.00 spread between the two strikes constant.
To see this, refer to the Table below.
Price- June 55 Call- June 60 Call- Spread
55 0 0 0
56 1 0 1
57 2 0 2
58 3 0 3
59 4 0 4
60 5 0 5
61 6 1 5
62 7 2 5
65 10 5 5
70 15 10 5
100 45 40 5
The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is $5.00 wide, $10.00 wide, $20.00 wide, or even $50.00 wide. Its maximum value is the difference between the two strikes. Further, the vertical spread’s maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45 – 60 put spread.
Again we set time forward to Friday, July expiration. We set the stock closing price at $60.00. At $60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put $0 – July 45 put $0). If the stock finishes at $52.50, then the July 60 puts will be worth $7.50 while the July 45 puts will still be worthless. In this scenario, the July 45 – 60 put spread will be worth $7.50 (July 60 puts $7.50 – July 45 puts $0). If the stock finishes at $45.00, then the July 60 puts will be worth $15.00 while the July 45 puts will be worth $0.
At this level, the spread is worth $15.00 (July 60 puts $15.00 – July 45 puts $0). This is the maximum value of the spread. As you can see, it is identical to the $15.00 difference between the strikes.
As the stock lowers, the July 45 puts become in the money and gain intrinsic value. For every penny that the stock decreases in value, the July 60 puts and the July 45 puts will gain value equally, keeping the $15.00 spread between the two strikes constant. To see this, refer to the table below.
Price- June 60 Put- July 45 Put- Spread
65 0 0 0
62 0 0 0
60 0 0 0
57 3 0 3
55 5 0 5
50 10 0 10
47 13 0 13
45 15 0 15
42 17 2 15
40 20 5 15
As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, $0. This means that in this strategy, both the buyer and the seller have a limited, fixed maximum loss.
The buyer can only lose what he spent. Therefore, if the buyer spent $2.20 to purchase the August 35 – 40-call spread, the most he can lose is the $2.20 he spent.
For the seller, the maximum loss is the difference between the maximum value of the spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35 – 40-call spread for $2.20 then your maximum loss will be $2.80. Remember, the maximum value of the spread is the difference between the 2 strikes or $5.00 (40 – 35).
The difference between the maximum value of the spread ($5.00) and the amount the seller received for the sale ($2.20) leaves a $2.80 maximum loss.
Below, the chart shows the potential amount of money, both profit and loss, that can be made or lost by both the buyer and the seller.
Closing – Aug 35-40 Call Spread – Aug 35-40 Call Closing Price - Buyer P & L – Seller P & L
30 2.20 0 -2.20 +2.20
32 2.20 0 -2.20 +2.20
34 2.20 0 -2.20 +2.20
35 2.20 0 -2.20 +2.20
36 2.20 $1.00 -1.20 +1.20
37 2.20 $2.00 - .20 + .20
38 2.20 $3.00 + .80 - .80
39 2.20 $4.00 +1.80 -1.80
40 2.20 $5.00 +2.80 -2.80
42 2.20 $5.00 +2.80 -2.80
44 2.20 $5.00 +2.80 -2.80
46 2.20 $5.00 +2.80 -2.80
48 2.20 $5.00 +2.80 -2.80
50 2.20 $5.00 +2.80 -2.80
It is important to understand and remember that vertical spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

Options Trading Mastery: Construction of the Time Spread

admin — Fri, 11 Dec 2009 03:37:23 +0000

Time spreads, also known as calendar spreads, are an ideal way to take advantage of time decay and changes in implied volatility. Time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, it is perfect for when you anticipate stagnant or explosive periods in a stock.
Time spreads, like other spreads, have their own risks and rewards. The risks are very limited for the buyer, but substantial for the seller. The seller’s risk can be avoided or contained with due diligence at the expiration of the near month’s option. Several strategies can affect the seller’s risk. The advantage of the time spread strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.
The construction of the time spread involves the purchase of one option and the sale of another in different months with both having the same strike. You can construct a time spread using either two calls or two puts. A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call, sell the August 45 call or buy April 30 puts, and sell February 30 puts. You can construct a short time spread by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.
The important elements in the construction of the time spread are: using two call or put options on the same stock, using the same strike for both, choosing different months for each and using a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is in a one to one ratio.
Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option’s extrinsic value is what decays over time. This is the basis of the time spread’s strategy. Since the time spread is built to take advantage of time decay, it is better suited for at-the-money options. This does not mean that you cannot use the time spread with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.
The rate of decay of an in-the-money or out-of-the-money option with one month until expiration is still greater than an in-the-money or out-of-the-money option of the same strike that has three months to go before expiration. This being said, the time spread can be constructed using any option regardless if it is in, out, or at-the-money.