Question: How can you benefit from short time spreads without freezing up your capital on margin?
Answer: Add an inexpensive back-month tail option.
Last month we explained how astute options traders can use a short time spread the same way as a long straddle but with a few slight twists.
The major negative for a long straddle (long call and long put at the same strike and expiration month) is that a large loss can occur when volatility contracts. The short time spread actually benefits from the volatility collapse, yet the two spreads appear to get amazingly close when viewed on a P&L (profit and loss) graph (see "Straddle vs. time spread"). The major negative for the short time spread is the margin requirement needed to place and maintain the position. When purchasing a time spread, most brokerage firms will margin the position at the net debit of the spread (in addition to commissions). Yet the Financial Industry Regulatory Agency, the Securities and Exchange Commission and the Options Clearing Corporation all have a more stringent view about short time spreads. The margin required to ensure a trader’s position goes beyond the risk.
The short call or put option in the back month is the biggest concern for a short time spread. Let’s use the IBM August/September 130 strike call time spread as an example:
Once August expiration passes, you are left with a short naked September call and increased risk. Novice traders will often margin the position as if it were a naked short call. Most brokers will margin this position at roughly $24,810 minus the credit received. This can be financially prohibitive for many traders and an inefficient use of margin capital. However, with a little planning, this margin can be significantly lowered by purchasing a cheap "tail" option in the back month.
Because your brokerage firm is concerned with the short September 130 call, you can simply purchase the September 140 call (trading now at $0.20) or the September 145 call (trading now at $0.06).
The resulting position will look like this:
You have lowered your net credit by the amount of the September call purchase, but you have also lowered your margin requirement to $7,900 (from $24,810). This is a 68% lower margin requirement. You also have slightly altered your position. You will be short a call (or put) spread in one month, but you will be naked long a call (or put) in the earlier month. This has the benefit of dramatically increasing your profit potential. Compare the earlier short time spread graph to the next one with the purchased margin reducing tail option (see "A better profile").
Once you learn how to calibrate options, positions can be tailored to your exact risk and reward tolerances. This is why traders equate options trading with playing chess as opposed to the stock trading game of checkers.
Edward LaPorte works with Random Walk, LLC, an options education company. Their website is RandomWalkTrading.com.
More options strategies:
Using a short time spread
The 1-3-2 trade
Buying downside puts to collar exposure