Fighting Time Value with Vertical Spreads (Part One)

02/18/2010 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Buying a long option is a great way to speculate on an expected increase or decrease in the price of a stock or ETF, but they also come with a couple of big disadvantages to account for when planning your trades.

First, long options have a time limit, or expiration date. If the market doesn't move in the direction of your forecast between the time you buy the option and expiration, you will lose your opportunity to profit.

The second disadvantage that faces long option buyers is the impact of time value. Even if the market moves the direction of your forecast, time value eats away at your profits and can turn a potential winner into a loser.

There is a partial solution to the second problem. You can reduce the impact that time value has on your long option trade by turning it into a long vertical spread. That means that you are still buying a long option, but you are selling another, further out-of-the-money option with the same expiration date against that long position.

The premium you receive from the option you sold helps to offset the decline in time value on the long option. Like short vertical spreads, a long vertical spread has a fixed amount of risk and a capped maximum gain.

Balancing the advantages and disadvantages as you evaluate spread opportunities starts with understanding how they relate to each other and how to construct the trade. When done correctly, a vertical option can be a great way to make money in an uncertain market.

In the accompanying video (see below link), I will walk through setting up a long put vertical spread on the QQQQ. Assume in this case that your attitude has become bearish on the market and you are expecting a drop in price, and therefore, a long put position looks good.

I will show you how to add a short put position (creating a long vertical put spread) against that long put to significantly reduce the cost of the trade and the impact of time value.

Watch a video with more details on LearningMarkets.com here.

By John Jagerson of LearningMarkets.com

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