Last week we kicked off a new series on calendar spreads, starting with a working definition and inching towards today’s topic: how to pick underlying stocks or indices that work well with a calendar strategy.

Making a calendar work: a few tips

Look for modest (but existing) volatility. I left off last week with a conundrum: if calendars are neutral plays, I want a stock that’s just dead, right? Wrong. We’re trying to capture time value with this play, so a stock with some volatility will have enough time value to make it worth our while. The trick is finding the right level of predictability to make a calendar really work.

Now I want to emphasize again that this series of posts will focus on one-month calendars. The volatility can be different if you’re willing to have a roll embedded in the price of the calendar. (We’ll get into more detail about that later in this post.)

Use this table as a rule-of-thumb for implied volatility levels that work pretty well for calendars:

$100 stock → 20% IV
$50 stock → 25% IV
$20 stock → 30% IV

Choose a predictable timeframe – NOT earnings season. Some traders like to get cute with a volatility skew or tilt around earning season, but I don’t care for this. Calendars are inherently neutral plays, so I want a reasonably active stock with fairly little news on the horizon before my back option expires. Earnings season, by definition, moves most stocks – how much is a big question mark. Why fight the core purpose of the strategy, when choosing an uneventful period can work just as well, with less stress?

So what is considered “good” for the skew? I would say flat skew, where the front-month contract trades for the same IV as the back-month or at least within a few percentage points. The difference in the rate of decay is enough to make the trade profitable if your forecast is correct. Flat skew implies you’ll have a better chance of being correct on your neutral outlook, so long as the implied volatility isn’t “out of whack”. Usually when there’s a large difference in implied volatility between the two contracts, that suggests an event (like earnings) might occur before the front-month expiration date.

Moral of the story is this: don’t just focus on the initial benefit of selling an option with a higher implied than the one you are buying. Try to up the odds of your forecast being correct.    

Consider stocks with a higher price. Options on a 100-dollar stock will have a higher premium than a 10-dollar stock, simply because it’s a 100-dollar stock. Look for a stock with a reasonably high price, so you can capture enough time value to make the trade worthwhile.

For calendars based on indices, consider adding a few “rolls”. Indices can make great underlyings for calendar spreads: historically they move, but not as unpredictably as an individual stock may. (If major news breaks on Wal-Mart, that rocks Wal-Mart’s stock a lot - but the index containing Wal-Mart relatively little.)

So what’s a roll? Adding a roll to our initial example might go like this: instead of selling a January and buying a February, we might buy a March. At the end of January, we could sell the February to replace it, leaving us with a Feb-March calendar and allowing us to capture the 30-day decaying option twice. Upon expiration of the March, we could close out the entire position.  It’s a more incremental play which can help you pick up enough time value to make the risk worthwhile. The downside to adding a roll is obvious: your neutral forecast has to hold true for a longer period of time.

If you like to buy the back-month more than 3 months out in time by embedding a few rolls in the strategy, think about doing so with an index versus a stock. There’s no specific quarterly earnings report for an index, although with that said it’s still best to avoid earnings season for indices as well as stocks. This time period can be tumultuous for every underlying.

What’s on tap for next week? We’ll continue with the tips, plus explain how you can add a little directional spin to your calendar spreads, if that’s your prediction.

Regards,
Brian (OG)

[image: ... by Gabriel M.A. on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.