Reducing Time-Value Erosion by Adding a Credit Spread

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The lead market news story from Reuters today made reference an unusual spread trade on the popular S&P 500 ETF (SPY) that was entered early in the trading session. The size was unusual, which made it newsworthy but the three three-legged structure was a little complicated. Although the components of the trade may have been confusing it is worth digging into as a good example of one of the purposes for option collars – to remove some or all time-value risk.

[VIDEO] Reducing Time-Value Erosion by Adding a Credit Spread

The three components of the spread could actually be divided into two trades. The first was a long, out of the money call with a strike price of $88 and an expiration in February 2009. The cost on that call was probably near $149 per contract at the time the trade closed . A long call is bullish by nature and has two kinds of risk. The position is exposed to market risk if the stock does not go the direction predicted and time-value risk that may make the position a loser if the market remains flat or does not move far enough in the right direction.

One way to reduce the time-value risk component is to sell a credit spread against the long position. The premium received from the short option spread will offset all or part of the time-value in the long call. Quite often the way this is accomplished is to sell a call with a strike price above the long call, creating a long vertical spread. However this will cap the gain potential. Selling a put spread is another way to accomplish a similar objective.

In this case the trader sold a put spread that was also out of the money at the 70 and 76 strike prices with February 2009 expirations. The premium from the put spread offset about 50% of the time value in the long call and left the upside unlimited. The out of the money put spread has reduced time-value risk, but since both the call and the put spread are directional trades there is still considerable market risk exposure.

There were 50,000 contracts involved in this transaction and if you look at today’s chain sheet on the SPY, volume spiked considerably at the strikes involved. The size of the trade and the fact that it was a very bullish position is what made this trade newsworthy. It is not everyday that a trader takes a $3.5 million dollar bullish position on the SPY these days. Whether this trader’s forecast is correct is uncertain but it is a good example for using a collar to take some of the sting out of time value. In the video, I will dig into more of the detail behind this trade and start talking about how the components could be modified depending on your own risk tolerance.

How did the trade workout?

Ultimately the trade was unsuccessful. At this writing (2/11/2009) 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 next 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. Selling options is a great way to trade in the market.