Reducing the Impact of Time Value on Options Trades

02/13/2009 11:39 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

This article is a follow up to an article originally published on 1/6/2009. If you have not read this article yet, start here.

The story behind this spread trading example originates with a surprisingly large and very bullish call purchase on the SPY earlier in January of 2009. The trader in this case purchased an amazingly large quantity of 88 strike price calls on the SPY in anticipation of a rally in the market.

The price of those calls included a very large quantity of time value. Time value is the enemy of option buyers because it can eat into your profits very quickly. In this case, the unknown trader offset a large portion of that time value risk by selling a short put spread with the long call position. The premium from the put spread offset a lot of the time value while not limiting the trade's upside potential.

Ultimately, the trade was unsuccessful. At this writing, the market has continued to trend flat with a slight bias to the downside. Expiration is around the corner on this spread, and a savvy trader may be looking for an exit. Although this was a bad trade, it is a great example of a successful execution of an option strategy.

In the video, I will walk through the results of this trade assuming the position was exited today. The put spread acted like a collar and helped contain the damage that could have been caused by time value. I will also contrast this outcome with a more aggressive example that could have been used in the same situation. The example will show the inherent flexibility in using spreads to control costs and risk. 

Watch the video now:

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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