Turn Back Time Value Through Spreads on ETFs
08/29/2008 12:00 am EST
Buying a long option is a great way to speculate on an expected increase or decline in value on a stock or ETF, but it comes with a couple of big disadvantages for which you have to account 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 facing 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.
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 are related to each other and how to construct the trade.
In the video below, 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 the Nasdaq, and therefore, a long put position is desirable on this ETF. I will show you how to add a short put position against that long put to significantly reduce the cost of the trade and the impact of time value.