Go long a time value spread at earnings

October 31, 2014 07:00 PM

Question:

How can you play an imminent earnings announcement that would offer no surprises?

Answer:

Go long a time value spread at earnings

Time value spreads also are known as calendar or horizontal (time horizon) spreads. Time spreads in futures contracts occur when you spread off one futures month against another. Long time value spreads in options occur when you go long an option in a deferred expiration cycle while simultaneously going short another option of the same strike in a more nearby expiration cycle. 

Why are they called time value spreads? Let’s look at the Google (GOOG) October weekly, October 577.50 call spread with GOOG at $577.70 for the week ending Sept. 26. The offer for the GOOG Oct (W) calls is $16.50. The bid for the Oct 577.50 calls is $13.90. The expiration value for both calls is 20¢. Every option of the same strike price will have the same expiration value regardless of when the expiration cycle expires. The expiration value is the in-the-money portion of the premium. It’s the differential in the respective time values that create the spread. 

When you are long a time value spread you want to take advantage of the time decay value of the nearby month. Let’s take a look at the long GOOG Oct (W) 577.50 — Oct 577.50 call time value spread. The Oct (W) options expire six days later than the Oct options. Let’s say that GOOG is trading at $625 at the end of the Oct expiration cycle. That means that your short GOOG Oct 577.50 calls will be assigned and the short calls will morph into short stock. You will be left with a position of short the GOOG stock against the long GOOG Oct (W) 577.50 calls. That works out to be a synthetic long GOOG Oct (W) 577.50 put position. 

Let’s say that GOOG is trading at $530 at the end of the October expiration cycle. The short Oct calls would then go out worthless. You would be left with a position of being naked long the GOOG Oct (W) 577.50 calls. 

Whenever you are long an option you want it to go to infinity. Whenever you are short an option you want it to go out worthless. The highest value for your long GOOG Oct (W) 577.50 calls while your GOOG Oct 577.50 short calls are worthless is @577.50. Any price above $577.50 means that the short Oct calls will be going up in price along with the long Oct (W) calls. At any price below $577.50 the short Oct 577.50 calls will be equally worthless but the long Oct (W) 577.50 calls will be losing value with each down tick in GOOG. That means when GOOG travels to $625 both the long and short calls will be deeply in-the-money. Their premium will be comprised almost entirely of expiration value and the time value spread will narrow in price. When GOOG travels to $530 both the long and short calls will be deeply out-of-the-money. Their premium will be comprised entirely of time value, of which very little will be left. Once again the time value spread’s price will have narrowed substantially. The sweet spot for any long time value spread is at its strike price. 

An increase in uncertainty for a stock, ETF or commodity means that there will be an increase in the time value that is embedded in an option premium. This is reflected in the implied volatility for an option. The higher the implied volatility, the greater the time value that is embedded in the option premium. The greater the amount of time left until expiration also means an increase in time value. 

The quarterly earnings cycle creates a great deal of uncertainty leading up to the announcement. 

The Oct (W) 577.50 calls that expire on Oct. 10 have an implied volatility of 16.8 while the Oct 577.50 calls that expire on Oct.18 have an implied volatility of 26.1. The earnings announcement for GOOG occurs on Oct. 15 after the close. The implied volatility for the GOOG Oct (W) 577.50 calls that expire on Oct. 24 is 25.5. If a trader is looking for a big move in GOOG the cheapest options that he could buy would be in the expiration cycle that is the closest to ending. That is because after a big move the time value in a deep-in-the-money option will be small regardless of the expiration date. If the implied volatility in the Oct options increases relative to the Oct (W) options that expire on the 24th then the spread will narrow in price. That is why you have to wait until the afternoon of Oct. 15 before you establish the spread. You would choose whatever the closest at-the-money time value spread is at the time. If there is not a big move after the earnings announcement you will be a big winner.

Dan Keegan is an instructor with the Chicago School of Trading. He may be reached at dan@thechicagoschooloftrading.com.

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.