Avoiding Option Time Decay using a Diagonal Calendar Spread

February 26, 2010

We know that many options expire worthless. Time decay eats away at the value of the option and it usually expires extremely devalued, typically as a result of time decay.

We can easily set up trades, while having a directional bias, and still avoid time decay. One way to accomplish this is by using a Diagonal Calendar spread. This can be done with puts or calls. This example will use puts.

The neat thing about this example is, not only do we avoid time decay, we actually set up the trade so that there is positive time decay – in other words, all other conditions equal, the position will make money over the passage of time. Positive time decay is an important characteristic of the Diagonal Calendar spread.

The Diagonal Calendar spread involves buying and selling puts. The key element here, the factor that gives this position positive time decay, is related to the months we are trading. A Diagonal Calendar spread consists of buying a put option while simultaneously selling a put option at a higher strike price. The option we sell must have a shorter time frame than the option we buy.

In this scenario, the option we buy has more time on it than the option we sell, and therefore, we have a situation with positive time decay. Because we are using puts in this example, we would like the market to rally. As it does, our shorter term puts gain more than we lose on our longer term puts. Note that the shorter term puts will have a higher delta than the longer term puts. The higher delta on the short puts, combined with the shorter time frame on our short puts, work together to make this a nice trade with positive time decay. Whenever possible, we try to avoid time decay or the theta factor from hurting our position. Below, there is a link to see this position in action, using Crude Oil Futures.

Click here to see a graphical depiction of this position. You can also see how it will perform over time.

Note: Theta, or time decay value is a positive number on this trade – +22.1. This means Theta contributes $22/day over the lifetime of this position.

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