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Time Spreads, also known as Calendar Spreads, are an ideal way to take advantage of time decay and changes in implied volatility. The time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, this strategy is ideal for use when you anticipate either stagnant or explosive periods in a stock.

The time spread, like other spreads, has its risks and rewards. The risk is 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. Also, there are a variety of strategies that can affect the seller's risk.

The advantage of this 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.

Construction of the Time Spread

The construction of the time spread involves the purchase of one option and the sale of another in different months, but 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 and sell the August 45 call or buy April 30 puts and sell February 30 puts. A short time spread is constructed by doing the reverse -- 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:

• Use two call or two put options on the same stock
• Use the same strike for bothChoose different months for each and use 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 done 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 (time value). An option's extrinsic value is what decays over time and is the basis of the time spread's strategy. Since the time spread is built to take advantage of time decay it is naturally better suited for at-the-money options.

This does not mean that the time spread cannot be used effectively 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.

However, the rate of decay (discussed below) 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.

Behavior of the Spread

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 so 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 may go 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 most of the time. 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.

Effects of Stock Price on the Time Spread

The price of a time spread will fluctuate with movements in stock price. A time spread will be at its widest when the stock price and the strike price of the spread are identical (i.e. at-the-money).

As the stock moves away from the strike in either direction, the value of the time spread will decrease. As the stock moves in either direction away from the spread's strike, the closer month will experience a quicker price change. This is due to the front month's higher sensitivity to delta changes, which is represented by the Greek letter gamma.

Gamma shows the rate of change of an option's delta in relation to movements in the price of the stock. It is the delta of the delta! Gamma is highest in at-the-money options and in the front month. It decreases as you move away from the at-the-money strike and as you move out over time.

In the same way that a time spread loses value as the stock price moves away from the strike price, the opposite is true also. As the stock price moves closer to the strike price, the value of the time spread increases.

For example, let's examine the June / July 65 call time spread. With the stock priced at $65 (directly at the strike) the spread is at its widest point (highest value) at $1.43. Now, as the stock climbs away from 65 and pushes toward $70, the June / July 65 spread loses value.

However, at the same time the June / July 65 loses value, the June / July 70 spread (not shown in the Table) would gain in value as the stock approaches the 70 strike. When the stock reaches 67.50 the point equidistant (mid-point) between the two strikes, both spreads will be trading at approximately the same value.

Look at chart 2. Notice that as the stock increases from 57.50, the June / July 65 and June / July 70 spreads increase in value. Their increases continue until they reach their strike price at which time they both begin to lose value.

This demonstrates that the spread with the strike price that the stock is moving toward will increase in value while the spread with the strike price that the stock is moving away from will simultaneously lose value.

Chart 2 follows the effect of the movement of the stock price across the two time spreads:

Effects of Volatility on the Time Spread

When purchasing a time spread, the investor should pay attention not only to the movement of the stock price but especially to the movement of volatility.

Volatility plays a very large roll in the price of a time spread and, as we have stated, the time spread is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.

Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let's start with option volatility.

An option's volatility component is measured by a term called vega. Vega, one of the components of the pricing model, measures how much an option's price will change with a one point (or tick) change in implied volatility. Based on present data, the pricing model assigns the vega for each option at different strikes, different months and different stock prices.

Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick). Remember, vega is given in dollars per one tick volatility change.

As we continue to discuss vega, keep these facts in mind:

1. Vega measures how much an option price will change as volatility changes.

2. Vega increases as you look at future months and decreases as you approach expiration.

3. Vega is highest in the at the money options.

4. Vega is a strike-based number -- it is the same whether the strike is a call or a put.

5. Vega increases as volatility increases and decreases as volatility decreases.

It is important to note that an option's volatility sensitivity increases with more time to expiration. That is, further out-month options have higher vegas than near term options. The further out you go over time, the higher the vegas become.

Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that vega values increase as you move out over future months; however, they increase at a faster rate.

The at-the-money strike in any month will have the highest vega. As you move away from the at-the-money strike, in either direction, the vega values decrease and continue to decrease the further away you get from the at-the-money strike.

Remember, vega (an option's volatility component value) is highest in at-the-money and out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike. Chart 3 below shows vega values for Qualcomm (QCOM) options.

As you look at the chart, observe the important elements: the stock price is constant at 68.5; volatility is constant at 40; time progresses from June to January; and finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time. For example, look at the June $65 strike. It has a vega of .053 in June and increases as you move toward January.

Also notice how the value decreases as you move away from the at-the-money strike.

Another important fact about vega is that it is a strike-based number. That means that the vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. So, the vega number of a call and its corresponding put are identical.

The chart below shows the vega values for calls and the corresponding puts. As you can see, these values match up in every instance.

Vega can also be used to calculate how much a specific option's price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved.

Multiply that number times the vega and either add it (if volatility increased) to the option's current value or subtract it (if volatility decreased) from the option's current value to obtain the option's new value under the new volatility assumption. The calculation works on individual options and can be used to calculate the value of the time spread.

Now, let's apply the concepts of vega to the Time Spread.

When you apply the vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher vega will increase more than the closer month option with the lower vega. That widens or increases the spread.

The chart below shows a time spread and its reaction to increasing volatility. As you can see, each time implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.

As you can see, if an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.

Of course, the vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher vega will lose value more quickly than will the nearer month option with its lower vega. In the chart below, you will see how the time spread's value is affected by decreasing volatility.

Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.

We discussed how to use vega to calculate an option's price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

Understanding and properly calculating accurate volatility levels is imperative for spread traders. In order to get accurate volatility levels, you must first determine a base volatility for the two options involved in the spread.

Getting a base volatility must be done because different volatilities in different months cannot, and do not, get weighted evenly mathematically.

Since they are weighted differently, you cannot simply take the average of the two months and call that the volatility of the spread; it is more complicated than that.

The problem is related to calculating the spread's volatility with two options in different months. Those different months are usually trading at different implied volatility assumptions. You cannot compare apples with oranges nor can you compare two options with different volatility assumptions.

It is important to know how to calculate the actual and accurate volatility of the spread because the current volatility level of the spread is one of the best ways to determine whether the spread is expensive or cheap in relation to the average volatility of the stock.

There are several ways to calculate the average volatility of a stock. There are also ways to determine the average difference between the volatility levels for each given expiration month. Volatility cones and volatility tilts are very useful tools that aid in determining the mean, mode and standard deviations of a stock's implied volatility levels and the relationship between them.

The present volatility level of the spread can then be compared to those average values and a determination can then be made as to the worthiness of the spread. If you now determine that the spread is trading at a high volatility, you can sell it. If it is trading at a low volatility, you can buy it. But first you must know the current trading volatility of the spread.

In order to accurately calculate volatility levels for pricing and evaluating a time spread, the key is to get both months on an equal footing. You need to have a base volatility that you can apply to both months. For instance, say you are looking at the June / August 70 call spread.

June's implied volatility is presently at 40 while August's implied volatility is at 36. You cannot calculate the spread's volatility using these two months as they are. You must either bring June's implied volatility down to 36 or bring August's implied volatility up to 40. You may wonder how you can do this.

Actually, you have the tools right in front of you. Use the June vega to decrease the June option's value to represent 36 volatility or use August's vega to increase the August option's value to represent 40 volatility. Both ways work so it doesn't matter which way you choose.

Let's use some real numbers so that we may work through an example together. Let's say the June 70 calls are trading for $2.00 and have a .05 vega at 40 volatility. The August 70 calls are trading for $3.00 and have a .08 vega at 36 volatility. Thus the Aug/June 70 call spread will be worth $1.00. To be able to calculate the volatility of the spread, we must equalize the volatilities of the individual options.

First, let's move the June calls by moving June's implied volatility down from 40 to 36, a decrease of four volatility ticks. Four volatility ticks multiplied by a vega of .05 per tick gives us a value of $.20. Next we subtract $.20 from the June 70 option's present value of $2.00 and we get a value of $1.80 at 36 volatility. Now the two options are valued at an equal volatility basis.

Looking at this first adjustment where we moved the June 70's volatility down to 36 from 40, we have a value of $1.80 at 36 volatility. The August 40 call has a value of $3.00 at 36 volatility. So the spread will be worth $1.20 at 36 volatility.

If you wanted to move the August 70 calls instead, you would take the August 70 call vega of .08 and multiply it by the four tick implied volatility difference.

This gives you a value of $0.32 that must be added to the August 70 call's present value in order to bring it up to an equal volatility (40) with the June 70 call. Adding the $0.32 to the August 70 call will give it a $3.32 value at the new volatility level of 40 which is the same volatility level as the June 40 calls.

Now, our spread is worth $1.32 at 40 volatility. August 70 calls at $3.32 minus the June 70 calls at $2.00 gives the price of the spread at 40 volatility.

It does not make any difference which option you move. The point is to establish the same volatility level for both options. Then you are ready to compare apples to apples and options to options for an accurate spread value and volatility level.

Since we now have an equal base volatility, we can calculate the spread's vega by taking the difference between the two individual option's vegas. In the example above, the spread's vega is .03 (.08 - .05). The vega of the spread is calculated by finding the difference between the vega's of the two individual options because in the time spread, you will be long one option and short the other option.

As volatility moves one tick, you will gain the vega value of one of the options while simultaneously losing the vega value of the other. Thus the spread's vega must be equal to the difference between the two options vega's. So, our spread is worth $1.20 at 36 volatility with a .03 vega or $1.32 at 40 volatility with a .03 vega.

Going back to our original spread value of $1.00 with a vega of .03, we can now calculate the volatility of that spread.

We know the spread is worth $1.20 at 36 volatility with a vega of .03. So, we can assume that the spread trading at $1.00 must be trading at a volatility lower than 36.

To find out how much lower, we first take the difference between the two spread values which is $0.20 ($1.20 at 36 volatility minus $1.00 at "x" volatility).

Then we divide the $.20 by the spread's vega of .03 and we get 6.667 volatility ticks. We then subtract 6.667 volatility ticks from 36 volatility and we get 29.33 volatility for the spread trading at $1.00.

We can also determine the volatility of the spread as the spread's price changes. Let's fix the spread price at $1.30. To calculate this, we must first take the value of the spread ($1.20 at 36 volatility) and find the dollar difference between it and the new price of the spread ($1.30). The difference is $.10. This dollar difference must now be divided by the vega of the spread. The $.10 difference divided by the .03 vega gives you a value of 3.33 volatility ticks. Then add the 3.33 ticks to the 36 volatility and you get 39.33 as the volatility for the spread trading at $1.30.

Let's double-check our work by calculating the volatility the other way.

This time we will do the calculation by moving the August 70 calls up to the equal base volatility of the June 70 calls. As calculated earlier, the August 70 calls will have a value of $3.32 at 40 volatility.

The June 70 calls are worth $2.00 at 40 volatility. Thus the spread is worth $1.32 at 40 volatility.

Now let's again move the spread price to $1.30, $.02 lower than the value of the spread at 40 volatility. As before, we take the difference in the prices of the spread. The result is $.02 ($1.32 - $1.30). Then, divide $.02 by our spread's vega of .03 (remember that the vega of the spread is equal to the difference between the vega of the two individual options). $.02 divided by .03 gives us a value of .67. That .67 must be subtracted from our base volatility of 40. That gives us a 39.33 (40 - .67) volatility for the spread trading at $1.30. This volatility matches our previous calculation perfectly.

At first glance, you might be wondering why we went through all of these calculations. With the June 70 calls at 40 volatility, price $2.00, vega .05 and the August 70 calls at 36 volatility, price $3.00, vega .08 why not just take an average of the volatility? This would give us a 38 volatility for the spread with a price of $1.00 when in actuality $1.00 in the spread represents a 29.33 volatility.

This would be almost a nine tick difference which represents a whopping 30% mistake! Because, as stated earlier, vega is not linear; you can not weigh each month evenly and just take an average of the two months. For argument's sake suppose you did. Let's say you found the difference of the vegas of the options and came up with a spread vega of .03 which is correct. However, when you try to calculate the spread's volatility and price you would have difficulty.

Now, recalculate the spread with the trading price of $1.30, or $.30 higher than your value at 38 volatility. Divide that $.30 higher difference by the spread's vega of .03. You get a 10 tick volatility increase. Add that increase to the base 38 volatility. That would mean you feel the spread is trading at 48 volatility instead of a 39.33 volatility! This type of mistake could be very, very costly. Remember, apples to apples, oranges to oranges. It doesn't matter which option's volatility of the spread you move as long as you get both options to an equal base volatility.

Buyer Risk/Reward

Like most trades, 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 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 a 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 spread. Thus the buyer's maximum risk is the cost of the spread.

The buyer can profit in several ways. First and foremost, being a 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 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 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, a time spread's 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 spread will expand and increase in value creating a profit for you, the buyer.

The buyer's risks are obviously the opposite of the rewards. You can not stop or reverse time so the buyer of the 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 a time spread, stock movement in the wrong direction can be costly. As the stock moves away from the spread's strike, the spread decreases in value. That will create a loss for the buyer of the spread.

Seller Risk/Reward

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 the sale of the time spread, the seller is looking basically for two things. First is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher vega in the out month option. This will cause the spread to contract or lose value. That will be profitable for the time spread seller.

Second, the stock can move. As stated before, a 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 spread. So, as long as the stock moves in either direction away from the strike, the seller's 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 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 of the time- spread seller.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 option's higher vega. This creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential. For the seller, the maximum loss potential is not so much determined by the stock 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 seller's short, out month option will increase more in value than will the seller's long, front month option. This will cause the spread to widen or increase in value; that is negative for the seller.

The second risk 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 does not move away from the strike significantly before the seller's long option expires, he 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 of the short option 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.

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.

Rolling the Position

Time spreads are unlike all the other strategies we have discussed before when we talk about rolling or continuing the position. In other strategies, the option component is limited to a single month. At expiration, the position disappears. It either transforms into stock or expires worthless leaving you with no option position. It is different in the case of a time spread because you are dealing with two different expiration months. After the front month expires, in addition to a potential stock position, you will still have an option position -- the out-month option will still have time until expiration. To properly roll that position, you must first understand the new position you have inherited.

Rolling the Call Spread

Let's look at the call time spread first. For the purposes of our example, let us pretend we are long the September / October 25 call spread. If the stock were to close below $25 on expiration Friday of September, the September 25 calls would expire worthless and you would be left with a long October 25 call position. From this position, you would have several things that you could do.

First, you could just sell out the October 25 call. Hopefully, the combination of the expiration of the September 25 calls and their subsequent worthlessness along with the proceeds gained from the sale of the October 25 calls after September expiration might make a profitable trade.

You could keep the position open and continuing in several ways. You could stay long the October 25 call naked. You could sell the October 30 call and become long the October 25 / 30 vertical call spread if you are bullish. You could sell the October 20 call and become short the October 20 / 25 vertical call spread if bearish.

You could buy the October 25 puts and become long the October 25 straddle if you felt the stock would become volatile. You could even sell the stock and create a synthetic put if you were very bearish. There are ways to create a new position that reflects any possible future outlook an investor can have.

If the stock were to close above $25.00, then the September 25 call would close in-the-money. At that time, you would be assigned your short September 25 call and that would translate into a short stock position. That short stock position that you received from the assignment of your short September 25 call along with the remaining October 25 long call position is the equivalent of a synthetic put. At this time, you could close out the position or keep it.

The position is a bearish one so if you felt the stock would be heading down, you could keep the position on. You could sell another option of a different strike to set up either a bull or bear put spread. You could buy the October 25 call to create a long straddle. As you see, there are many different combinations that could be created.

If you were short the September / October 25 call time spread and the stock expired under $25 on expiration Friday of September, then you would have a remaining position of a short October 25 call naked. Again, there are many potential ways of continuing the position. Of course, you could always buy back the naked call and close the position if you no longer wanted to maintain a position in the stock.

If you did, you could buy a call in the same month and create a vertical spread, sell the corresponding put and create a short straddle, buy the stock one to 1 and create a buy-write or other combination based upon what you felt the stock would do.

If the stock closed above $25 and you were short the call time spread, then you would be left with a long stock position from your long September 25 call and short the October 25 call against the long stock position. The position you would be left with is a buy-write. Depending on your outlook for the stock, you could keep the buy-write on, take it off, or use other options to change the position to what you want it to be.

Rolling Put Spreads

As far as put spreads, let's take an example and see where we are when the front month option expires. We will use the September / October 25 put spread for our example.

When long the spread, and the stock closes above $25, the September 25 puts, which you are short, will expire worthless leaving you with a long naked put position. From that position, you can close it or combine it with other option or stock to create a different position. Again, there are many different possibilities.

If you were short the put time spread, and the stock closed above $25 then the September 25 put, which you are long, will expire worthless leaving you with a short naked put position in the October 25 puts. This position can be closed out or combined with other options or stock to create a strategy that will take advantage of the outlook you have on the stock.

When the stock closes below $25.00, the scenario is different. When long the spread with the stock closing lower than the strike price, the front month put which you are short will be assigned to you thus making you long stock in addition to your long October 25 put. This position is known as a synthetic call.

As before, there are many ways to combine other options and/or stock to change the position so that it is in line with want it to be going forward.

If you were short the spread, and the stock closed below $25, then you would exercise your long September 25 put making you short stock and short the October 25 put. That position, which is called a "sell-write" (the sister strategy to the buy-write), can be kept as is, closed out, or changed in different ways by combining it with stock or other options based upon your expectations of the stock's future movements.

Closing the Time Spread Position

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.

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.

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.