Why do many options traders watch their underlying stock’s movements carefully – and ignore volatility altogether? Often traders don’t realize how much volatility changes can impact their positions. This post continues an ongoing series on volatility in options trading, focusing on calendar or time spreads. Welcome yet again to my series on volatility in options trading. My first post defined 3 key volatility terms: implied versus historical volatility and vega, the Greek measuring volatility’s affect on an option’s price. Post 2, Volatility: When Vega Trumps Delta, explained how volatility crunch can prey upon long options faster than you realize.
Post 3 dealt with volatility and long call spreads, and post 4 expanded that discussion to volatility and short call spreads.
Let’s clarify two things: first, I’ll be referring to “implied volatility”, “volatility” and “IV” interchangeably in this post. Second, never forget that, 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’s no guarantee that this forecast will be correct.
Today we tackle a more advanced strategy, calendar spreads, also known as time spreads. Spreads are multiple leg option strategies that involve additional risks and multiple commissions, and may result in complex tax treatments. Be sure to consult with your tax advisor before engaging in these strategies. Here’s a brief recap of a calendar spread, although you can find all the details if you log in to your TradeKing account and go to Education > The Options Playbook > Play #27, Long Calendar Spreads with Calls:
• Sell a call, Strike Price 50 (near-term expiration, aka "front-month")
• Buy a call, Strike Price 50 (with expiration one month later, aka "back-month")
• Generally, the stock will be at or around 50
• Commission at TradeKing is $11.20 to establish the play ($4.95 plus $0.65 for each of 2 legs)
This theoretical calendar spread takes advantage of the fact that the front-month call decays at a more accelerated rate than the back-month option, especially as expiration approaches. Just before front-month expiration, you’d like the stock to be close to 50 so you can buy back the shorter-term call for next to nothing. At the same time, you’d sell the back-month call to close your position, hopefully capturing some time value.
Your max potential profit is limited to the premium received for the back-month call minus the cost to buy back the front-month call, minus the net debit paid to establish the position and the commission. Your max potential risk, on the other hand, is limited to the net debit paid to establish the trade (if the entire position is closed prior to front-month expiration).
Most traders think of calendar spreads as a time-decay play, one in which you want minimal movement on your underlying stock. While that’s technically true, there’s a lot more nuance to the volatility side of things than you might realize. Considering calendars a time decay, many traders mistakenly conclude that decreasing implied volatility is their best bet. This is simply not the case.
Let’s explain this idea, again using at-the-money (ATM) calls. As I noted in Volatility: Wobbling Your Spread?, ATM options are most susceptible to volatility swings because time premium is maximized with these options. Say you were considering a perfectly ATM calendar spread like this one:
XYZ @ 100
Buy 1 60-Day 100 Call @ 3.50
Sell 1 30-Day 100 Call @ 2.50
Net Debit of 1.00
Commission at TradeKing is $11.20 to establish the play
Let’s say you’re correct in your forecast and XYZ stays at 100 as expiration nears. What happens to your front-month option? Since all is going so well, the front-month call you sold will expire worthless at expiration, letting you keep the premium.
Now you’re left with just the second leg, the XYZ 100 call you bought – in other words, you’ve gone from being a calendar spread trader to a long call owner. Now what’s your stance on implied volatility? Long calls and puts benefit from elevated volatility, so you’re rooting for IV to increase.
Now you can see calendar spreads’ more nuanced relationship with IV. Since you’re dealing with a time decay play, most traders think dropping IV goes hand-in-hand with that. Lowering IV does decrease the front-month’s risk, but that front-month will be expiring anyway. If IV drops, it hurts the back-month option more than it helps the front-month option, because the back-month option usually has more time premium in it.
In other words, whether your forecast is correct or not, with calendar spreads you’d always like IV to increase overall after the play is established. So therein lies the paradox and challenge of this trade: you want the market to stay flat but prefer the IV to increase.
There’s still one concept we haven’t tackled, and that is volatility tilt between the expirations. This will occur especially around an event like earnings. In a nutshell, “volatility tilt” refers to the fact that the IV for options don’t always move in tandem between the front-month expiration and back months.
To address this, in the next post we’ll look at a live real example of a calendar trade around an earnings event. We’ll also show the effects of IV using vega for the entire position. Stay tuned!
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
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