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/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 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.
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