Option trading strategies offer traders and investors the opportunity to profit in ways not available to those who only buy or sell short the underlying security. One such strategy is known as the "calendar spread", sometimes also referred to as a "time spread". When entered using near or at-the-money options, a calendar spread allows traders to profit if the underlying security remains relatively unchanged for a period of time. This is also referred to as a "neutral" strategy.
When entering into a calendar spread it is important to consider the current and future anticipated level of implied volatility. Before discussing the implications of changes in implied volatility on a calendar spread, let's first look at how a calendar spread works and what exactly implied volatility is. (For a primer on volatility, take a look at The ABCs Of Option Volatility.)
The Calendar Spread
Entering into a calendar spread simply involves buying a call or put option for an expiration month that's further out, while simultaneously selling a call or put option for a closer expiration month. In other words, a trader would sell an option that expires in February and simultaneously buy an option that expires in March or April or some other future month. This trade typically makes money by virtue of the fact that the option sold has a higher "theta" value than the option bought, which means that it will experience time decay much more rapidly than the option bought.
However, there is another factor that can profoundly affect this trade, and that relates to the Greek variable "vega", which indicates how much value an option will gain or lose due to a 1% rise in volatility. A longer term option will always have a higher vega than a shorter term option with the same strike price. As a result, with a calendar spread, the option purchased will always fluctuate more widely in price as a result of changes in volatility. This can have profound implications for a calendar spread. In Figure 1 we see the risk curves for a typical "neutral" calendar spread, which will make money as long the underlying security remains within a particular price range. (Refer to our Option Greeks Tutorial to learn more about theta and vega.)
|Figure 1: Risk Curves for a neutral calendar spread|
|Source: Optionetics Platinum|
At the present implied volatility level (of around 36% for the option sold and 34% for the option bought), the breakeven prices for this example trade are $194 and $229. In other words, as long as the underlying stock is between $194 a share and $229 a share at the time the shorter-term option expires (and assuming no changes in implied volatility), this trade will show a profit. Likewise, barring any changes in volatility, the maximum profit potential for this trade is $661. This will only occur if the stock happens to close exactly at the strike price for both options at the close of trading on the day that the option sold expires.
The Effect of Changes In Implied Volatility
Now let's consider the effect of changes in implied volatility levels on this example calendar spread. If volatility levels rise after the trade is entered, these risk curves will shift to higher ground - and the breakeven points will widen - as a result of the fact that the purchased option will increase in price more than the option that was sold; this occurs as a function of volatility. This phenomenon is sometimes referred to as the "volatility rush". This effect can be viewed in Figure 2 and assumes that implied volatility rises 10%.
|Figure 2: Risk curves for a calendar spread if implied volatility is 10% higher|
|Source: Optionetics Platinum|
After this higher volatility level, the breakeven prices are now $185 and $242 and the maximum profit potential is $998. This is due solely to the fact that the increase in implied volatility caused the longer-term option that was purchased to rise more than the price of the shorter-term option that was sold. As a result, it makes sense to enter into a calendar spread when the implied volatility for the options on the underlying security is toward the low end of its own historical range. This allows a trader to enter the trade at a lower cost and affords the potential for greater profit if volatility subsequently rises.
On the other end of the spectrum, what traders need to also be aware of is the potential for something known as the "volatility crush". This occurs when implied volatility falls after the trade is entered. In this case, the option purchased loses more value than the option sold simply due to its higher vega. A volatility crush forces the risk curves to lower ground and greatly shrinks the distance between the two breakeven points, thus reducing the probability of profit on the trade. The other piece of bad news is that the only defense for the trader in this case generally is to exit the trade, potentially at a loss. The negative impact of a decline in volatility on the profit potential for our example calendar spread trade appears in Figure 3.
|Figure 3: Risk curves for a calendar spread if implied volatility is 10% lower|
|Source: Optionetics Platinum|
Following this decline in implied volatility, the breakeven price range for this trade has narrowed to the $203 to $218 price range, and the maximum profit potential has dropped to just $334.
Figure 4 summarizes the effects of changes in implied volatility for this example trade.
|Figure 4: Impact of changes in implied volatility|
A calendar spread is an option trading strategy that makes it possible for a trader to enter into a trade with a high probability of profit and a very favorable reward-to-risk ratio. As with all things however, there is no free lunch. And in this case, what you see may not be exactly what you get. While the risk curves for a calendar spread may look enticing at the time the trade is being considered, a trader needs to carefully assess the present level of implied volatility for the options on the underlying security to determine whether the present level is high or low historically. Likewise, the trend of implied volatility is important. If volatility is expected to rise, the prospects for a positive outcome are much greater than if volatility is trending sharply lower.
As with most everything that you buy and sell, it is extremely important to know if you are paying or receiving a lot or a little. When it comes to option trading, the tool to use to make this determination is the variable known as implied volatility. If IVis high, the odds favor those who write options, or sell premium. When IV is low, the odds favor those buy premium. Ignoring this critical piece of information is one of the biggest mistakes any option trader can make.
For related reading, take a look at Gamma-Delta Neutral Options Spreads.
Credit & LoansThese terms may sound the same, but they mean very different things for homebuyers.
Options & FuturesInvesting during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
InsuranceTough times call for desperate measures, but is raiding your life insurance policy even worth considering?
Fundamental AnalysisA decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
Options & FuturesLearn the 10 steps that lead up to closing the deal on your new home and taking possession.
Options & FuturesTerrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
Mutual Funds & ETFsWith more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
Mutual Funds & ETFsInvestors have much to consider when they’re deciding between ETF and index options. Here's help in making the decision.
Options & FuturesDiscover how this sophisticated trading technique can unlock significant gains while reducing your losses.
Options & FuturesDiscover some of the most popular apps that options traders use so they can stay on top of market opportunities and manage their investments.
With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>