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Ask the Institute

DATE: April 01, 2013

QUESTION:

Can you explain how time decay works on a credit spread position?

ANSWER:
A credit spread is a vertical spread in which the option that you sell is more expensive than the option that you buy. As a result, the strategy is established for a net receipt of money. Hence, the name credit spread. To analyze how time decay will affect a credit spread position, let’s construct a credit spread position with calls using XYZ stock which is currently trading at $58 per share. First, sell one XYZ May 60-strike call at $3.00 per share and simultaneously buy one XYZ May 65-strike call at $1.00 per share. Since the May 60 call has a higher price than the May 65 call, the resulting May 60/65 call spread is sold for a net credit of $2.00 per share.

In this credit spread example, you are selling the close-to-the-money 60-strike call and you are buying the out-of-the-money 65-strike call. Time decay will be greatest for at-the-money and close-to-the-money options. As a result, the 60-strike call will experience more time decay than the 65-strike call. To learn more about how time decay works on a credit spread position, view this week's segment of "Ask the Institute."


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