When you’re trading options, you can choose from three types: direction, volatility, and time. (We cover all three in detail in our book Know Your Options.) A trade based on time requires a time spread – and a more nuanced approach.
When I’m using time, I estimate how/when a stock is going to move, and based on that assumption, I can reduce risk by a substantial amount. It is a tough task, and very difficult to perfect, but this tactic is not about being perfect. It is about being close enough, which is good enough to book a win.
An example of a winning time spread
Our chat room recently had a very successful time spread setup. The stock we looked at was Costco. The big retailer was scheduled for their Q1 earnings report on May 29. As is customary, the options (both calls and puts) were very expensive, because prior moves were quite large.
Remember, the options market is about implied moves, so the expected move is price according to historical precedent. For example, if over the last five earning periods the stock moved 3-5% up or down, you could expect to see the options price set to the same sized move in front of earnings. The market is not going to mis-price a stock that could have a large move against a market maker’s position.
In this case, Costco was expected to move about 4%, or roughly $50, up or down post-earnings. We calculated the spread based on the call and put being at-the-money.
As it turns out, the shorter duration option that was expiring one day after earnings was extremely expensive. This was a bit unusual: As you move along the time horizon of option expirations, the expected move grows larger. But the May 30 option was the most sensitive to the earnings report, because it would expire the following trading day.
Here was my trade set up
Buy the June 20 (monthly expiration) 1030 strike call option on Costco; this was the bullish portion of the trade. It was selling for $24, or about 2.5% of the current stock price ($1,000). That seemed a bit pricey to me, but given the expected move, I was pretty confident this one could work.
I priced in the May 30 1050 call at $7. I figured selling that strike might be a good way to reduce my risk; this was the bearish side of the trade.
But here’s where the risk reduction really came into play: Selling May 30 call (for $7) against the long June 20 call (for $24) reduced my risk by 29% and kept my direction bullish. I would only run into an issue if the stock had a monster move of, say, $80-100. That kind of move would be a huge, unexpected outlier event (but of course, anything is possible).
How the trade played out
Costco only moved $30 post earnings, slightly less than it was priced for. I sold the June 30 call on June 2 for a nice gain at $32. The net win on this trade was about 92%
This is what Sam does in our Spread Trader service: place lower risk trades and help his subscribers make money. For just $109 a month, the membership is a great way to learn and make money at the same time.
