Why do many options traders undervalue the importance of volatility? Traders may not realize how much volatility changes can impact their positions – even more than the underlying’s action. This post continues an ongoing series on volatility in options trading, focusing on calendar spreads. Welcome yet again to my volatility in options trading series. My first post outlined 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 preys on long options. Post 3 dealt with volatility and long call spreads, and post 4 moved on to volatility and short call spreads.
Don’t forget: 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 look again at calendar spreads (aka time spreads), focusing on a phenomenon known as volatility tilt that can affect calendars around earnings season.
(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.)
If you’re unfamiliar with calendars, brush up by reading my previous post and/or go to Education > The Options Playbook > Play #27, Long Calendar Spreads with Calls. You’ll need to login first.
A calendar example: Google (GOOG)
I have a real-life example for you from a TK client that ended well but also teaches this lesson nicely. Here’s the setup: Google was trading at 422.60 on 7/16, with earnings to be announced after the close. This trader expected GOOG to make a 5% move to the downside.
With one day remaining in the July expiration and 36 days in the August, this trader entered the following calendar:
Buy 1 Aug 420 put @ 10.00, IV 34 %, vega .50
Sell 1 Jul 420 put @ 2.95, IV 80%, vega .09
Net debit of $7.00
Commission is $11.20
The first thing you might notice is the large difference in Implied Volatility between the July option IV and the Aug option IV; this is often referred to as volatility tilt.
Vol tilt is commonplace around an earnings report. Many beginning traders notice this situation and try to use calendar spreads to take advantage. Their plan is to sell the extremely high IV in the near-term expiration month, then buy the lower IV in the back month. The calendar is usually done as a direction play using out-of-the-money calls if bullish and OTM puts if bearish - as is the case here. Now the most commonly overlooked part of this trade is the vega that goes along with each option.
As I described earlier in this series, vega is defined as the amount a theoretical option's price will change for a corresponding one-percent change in the implied volatility of the option contract. Read more about vega here.
Vega is usually a larger number for options with more time value in them, as is the case in our example. We’re long the August contract, which has a vega of .50 and short the July contract; that has a vega of .09. Keep in mind that the July contract only has one day remaining. Because of this, all the time value will definitely be gone at the close of the market the next day.
That scenario is what the trader was hoping for; basically he was trying to buy the long August put at a discount. If the stock went down, but not all the way down to 420, the short July put would expire worthless and leave him net long the August contact, while pocketing all the premium received from the short option sale.
The client was correct on his bearish forecast, and Google’s stock dropped 12.35, closing at 430.25. The client closed out the position on the close the next day and had a profit on the 1x1 calendar spread after commissions of $200. You might be asking yourself, though (as this trader did): why so little profit? The answer is in the vega.
The July option is easy to figure out: it only had one day remaining and the option finished out of the money, so the advantage was 2.95 cents to the profit of the position because the option expired worthless.
But the back month we need to use vega to determine what happened. If you recall the August vega was .50 -- nothing to sneeze at. So after earnings were announced and Google made a relatively small move of 2.8%, the IV came off across all the option contracts in the chain. In the August option the IV went from 34% to 25%, a 9% point drop.
Let’s do the vega math and translate that into dollars. 9% x $.50 = $4.50. So we gained $2.95 from the short option because it expired worthless, but we lost $4.50 in the back month because of a volatility crunch that started as volatility tilt. So this is ultimately why the trader was disappointed in the return.
The story ends happily, since that the trader made a profit and still learned a lesson. But that’s not usually not the case. If you’re trading calendar spreads on stocks around news events, you’d better understand vega and how it may affect both option contracts after the news comes out.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
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