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B. Venkatesh

CONSIDER this: You observe that the December (near month) Nifty 1640 calls trade at Rs 28 per option, and the January Nifty 1640 calls (farther month) trade at Rs 65 per option. You buy the January calls, and simultaneously sell the December calls to reduce your cost; your net outflow will be Rs 37 (Rs 64 less Rs 28) per option. You have constructed a long-time spread. Beware the risk!

Such a strategy will be profitable only if Nifty does not move or moves very slowly till the near month contract expires. The reason? The slower the Nifty moves, the faster the near-month option will lose value because of time decay.

When you buy a call option, you expect the underlying stock to move up before the expiry of the contract. The slower the stock moves, the lesser the possibility of the call option becoming profitable before the contract expires.

The loss in option value due to passage of time is called time decay. Since you have sold the near month contract, you will profit from time decay. The option will either expire worthless or you can buy it at a lower price and close the position. The farther month contract (January) will also lose value due to time decay. But that contract still has more time to expiration. So, the loss due to time decay will be slower for farther month contract than for the near month contract.

Suppose the Nifty moves up soon after you buy the time spread. Both calls will also move up sharply. But the profits from the January calls will be offset by the losses from the December calls. That is, the price difference between both calls will be zero or near zero. You will, hence, lose money because you bought the spread at Rs 37 per option.

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