This week a “Members Only” article was published that presented a strategy that can generate a profit if the price of a stock or index moves sideways, moves up, or moves down. The position is not risk free. The risk characteristics were examined in detail with some possible ways to reduce or eliminate that risk were also discussed. This evening I want to discuss a longer term strategy that can generate a profit if the price moves sideways or in the “right” direction by using a Time Spread, whether it is a Diagonal spread or a Calendar spread.
In previous articles we have discussed the characteristics of buying calls and puts and we have examined selling premium. The Diagonal and Calendar spreads involve both types of positions. But first we need to look at the minor differences between these two types of spreads. The one thing they do have in common is that you BUY an option that has a lot of time, usually a few months to a year or more with the use of LEAPS. The second thing that they both have in common is that you sell a current month strike. The difference between these 2 spreads is that the calendar spread involves using the same strike (such as Selling a Jan 35 call and buying a May 35 Call) while the Diagonal spread involves different strikes (Selling a Jan 35 call and buying a May 30 Call).
A time spread is a good way to take advantage of a long term trending move. Here is a monthly chart of the QQQ tracking stock to show some of the longer term moves that have taken place.
What this monthly chart shows is that on the Q’s from the end of 2018 to the end of 2019 the price made a 20 point move. In 2020 there was another very long term move that took place that covered more than 12 points.
In this article we are going to examine ways to profit from moves such as this by using a Time Spread position.
The 2 moves that are highlighted above lasted approximately 1 year each. And because this is a “trending” type of strategy you are unlikely to catch the exact top and bottom, your goal though is to catch as much of the trend as possible.
Philosophy of the position
With a time spread there are two objectives, and I am going to discuss these separately to help break down the complexities of the Time Spread position to the basics of the position so we can see what will be taking place as time goes by.
The first part of a Time Spread position is the purchase of an option that has a lot of time until it expires. Basically you are buying a call or a put, depending on which direction you feel the stock or index will go, and you do want the price to make a large move in that direction. On the above chart we have the price that fell from 40 to 20, and has bounced back to near 40. For this next part of the article, we are going to take the perspective that the price will fall back to 20, and that it could take 12 months for the price to make that move. At this time we have the 2020 options available for March and June. Neither of which gives us the 12 months that we are looking for, so we look at the very long term options and see there are Jan 2006 options. When we look at the option chain for Jan 2020 we see that the 39 Put would cost $3.40. This strike is ITM (In The Money) and does have almost $1 of real value to it). The 38 Put would cost $2.95 and it is ATM (At The Money) and all of this is in time value. We also have the 37 Put that would cost 2.55 which is 1 strike OTM (Out of The Money). Arguments could be made for the selection of any one of these strikes. What it will come down to is that you will select one of these strikes to purchase.
Once the strike has been selected and purchased the trade has begun, and your primary objective with this part of the trade is for the price of the q’s to move down where the put that was purchased will gain real value.
IF the q’s move up instead of down, then you will have a problem as the put you purchased will not have any real value, and it will be losing time value. A move above the 40 area would start to seriously impact this part of the position, with the higher the move goes the more damage that is done.
The long term option that is purchased also servers as “collateral” so you can place the second part of the position, the selling of the near term premium. In theory you want to use time to your advantage and sell the near term puts enough times to pay for the put that you bought. For this particular position we are looking at buying the Jan 2020 option, this gives us all 12 expiration cycles in 2019, plus the Jan 2020 expiration AND also the Dec. 2018. We have 14 expiration cycles that we can sell premium in. Because you already own the Jan 2020 put all we are looking at doing is selling a Dec. put. When it expires we will then sell a Jan. 2019 put, and so on each month until we reach Jan. 2020.
The most expensive put that we could have bought was $3.40. If we take that amount and divide it by 14 (the number of months that we can sell) we find that we only need to collect 25¢ each month to collect enough premium to pay for the put we purchased. There is one other factor that we need to take into consideration, and that is the cost of trading. Somewhere along the way we will need to collect a little more than a quarter to pay for all of the commissions on the trades that are placed with this strategy. There is one thing to keep in mind, is that the near term put we sell will need to be far enough OTM that it expires worthless, because if the price does move beyond that strike where it is In The Money, it could take us out of the position before the year is up, or wind up costing money that will ultimately eat into the potential profits, or turn the overall position into a loss.
We will start by looking at the Dec. 2018 puts. We have the Dec 2018 37 put at 40¢ and the 36 put at 20¢. Now the fun begins as we enter the complicated part of the position. If we sell the 37 put we collect more than our quarter, and we are well on our way to paying for the put we bought. If we can get this much in premium every month, we could wind up with a decent credit at the end of the trade. This would be extra profit on top of any real value gains in the price of the option we bought! Or if the price of the q’s is at 38 in Jan 2020, at least we would have a small profit from the near term premium we have sold.
But, if the q’s drop below 37 before that Dec contract expires it will cause us some pain and problems. While the 36 put is at 20¢ and not quite the quarter we want every month, it is a little bit safer, but not completely safe as the monthly chart of the q’s does show a move of 2 to 5 points per month is quite normal.
There is one other small issue about this part of the position where we sell the near month option. It is going against the underlying basis of the option you bought. The first part of the Time spread is buying an option and wanting the stock or index to make a strong move in that direction. The second part of the position is basically saying “just don’t make that move right now”.
While the philosophy of this position is very simple, you want to buy an option that will gain in real value as the price of the stock or index makes a long term trending move, and to offset the cost of the option you bought you want to sell the near month premium each month. What will make or break this position is whether you correctly pick the direction of the trend, and how well you do with selling the near month premium each month.
We have examined what a Time Spread is, and the individual parts that make up the position. We have also looked at the philosophy of the trade and what we want it to do. And we also see that there is a twist with how one part of it is going against the other part, which does add to the complexity of the position. In the next article we will look at some actual charts and show how the TimeFrameInvestor time frame analysis feature can help you with the issues that pertain to this type of a position.