Like most trades, time spreads have a maximum loss for the
buyer. As a buyer, you can only lose what you have spent. If you
paid $ 1.00 for the spread then your maximum potential loss is
that $ 1.00. If you bought the spread for $ 2.00, then $ 2.00 is
the maximum potential loss.
The buyer of a time spread will be purchasing the out-month
option while selling the nearer month option of the same strike
in a one-to-one ratio. Since the out-month option will have more
time until expiration than the nearer month option, the
out-month option will cost more. This means the buyer will be
putting out money (debit spread) which makes sense. The buyer
can only lose the amount of money they spend to purchase the
spread. Thus the buyer's maximum risk is the cost of the spread.
The buyer can profit in several ways. First and foremost, being
a time spread, the buyer can profit by the passage of time.
Options are wasting assets. So as the nearer month option decays
away more quickly than the outer-month option, the spread widens
(increases in value) and the buyer sees a profit.
Second, implied volatility can increase. As implied volatility
increases, the out-month option, which the buyer is long,
increases in value more quickly (due to its higher vega) than
the nearer month option which the buyer is short. This will
force the spread to widen or increase in value, which again is
profitable for the buyer.
Third, the buyer can make money due to stock price movement. As
stated before, a time spread's value is at its maximum when the
stock price and the spreads strike price are identical
(at-the-money). You could have an increase in value if you owned
an out-of-the-money or in-the-money time spread, and the stock
moved either up or down toward your strike. As the stock moves
closer to your strike, the spread will expand and increase in
value creating a profit for you, the buyer.
The buyer's risks are clearly the opposite of the rewards. You
can not stop or reverse time so the buyer of the spread can
never be hurt by time.
Implied density, however, can decrease as easily as it can
increase. A decrease in implied corruption will decrease the
value of the out-month option (which the buyer is long) faster
than it will decrease the value of the nearer month option
(which the buyer is short) due to the higher vega of the
out-month option. This will narrow the spread thereby creating a
loss for the buyer.
In the same way that stock movement in the right direction can
be profitable for the buyer of a time spread, stock movement in
the wrong direction can be costly. As the stock moves away from
the spread's strike, the spread decrees in value. That will
create a loss for the buyer of the spread.