TIME VALUE SPREAD

Time Value spreads are also known as calendar or horizontal spreads (time horizon). A long, time value spread occurs when you go long and option in a deferred expiration cycle and short an option with the same strike price in a more nearby expiration cycle.

Why is it called a time value spread? SPY closed at 434.31 on February 18th, 2022. Options premium consists of expiration value and time value. When an option expires it has no time value left. If it is out of the money, then it has no expiration value and it is worthless. If it finishes in the money, then its value is the difference between the strike price and the price of the underlying value (UV). The UV can be an equity, futures contract, exchange traded fund (ETF) or index.

When you are long an option you want it to move higher and higher to infinity. When you are short an option the dream scenario is for it to go out worthless. When the short option goes out worthless then the long option obviously has not gone up to infinity. When the long option goes up to infinity then the short option just as obviously doesn’t go out worthless.

Let’s take the example of the SPY 11Mar-25Feb 433 call, time value spread. SPY is trading at 434.41. If that is the price of SPY at expiration, then the calls expire at the price of 1.41. The 11Mar 433 calls are priced at 11.08 with a time value of 9.67. The 25Feb 433 calls are priced at 6.92 with a time value of 5.51. The debit for this spread is 4.16. That is the most that can be lost on this spread.

This spread peaks in value when the SPY 11Mar 433 calls can be priced as high as possible while the 25Feb 433 calls still go out worthless at expiration. Nobody will exercise the SPY 25Feb 433 calls if the price of SPY is 433 or lower. The calls need to be in the money if they are to be exercised. It appears then that the perfect price at the February 25th expiration is 433. At 431 the front cycle calls still go out worthless but the back cycle calls are not worth as much as they would be at 433. Each downtick from 433 makes the SPY 25Feb-11Mar 433 time value spread less and less valuable. What happens above 433 at expiration? The short calls are then assigned because the holders of those calls have exercised them. The short calls then morph into short ETF shares. This means that with every uptick in SPY the price of the shares rise more sharply than the price of the long calls. As the long calls get deeper and deeper in the money the respective values of the long call and short ETF tend to move in lockstep. The P & L Graph below illustrates this. The black graph is the P & L for February 18th and the blue graph is the February 25th expiration graph. Notice that the initial graph starts out as a frown that turns into a mountain peak at the February 25th expiration, assuming the ETF stays in a tight range. If SPY moves outside that range then adjustments need to be made to keep the trade profitable.


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