Are You in the Riskiest Option Trade Around?

10/18/2010 11:32 am EST

Focus: OPTIONS

As an option mentor, I’ve seen just about every option trading strategy around. One that is popular is the long-term calendar spread. This is a trade where one would sell the front month, then buy a corresponding option several months out. There are times when it can make sense to put on a long-term calendar. This is not one of those times. Never have we seen such unbelievable contango between the months. I am not normally a VIX guy, or even much of a VIX futures guy; however, it doesn't take a volatility expert to see the gigantic spread between VIX and VXV. The spread backed off a touch last week, but is near unbelievable widths:


Click to Enlarge

One should also notice the serious contango in the futures. It is bad between October and November and November and December (although I would note October is still trading almost two points higher than the cash). As the months get further from expiration, the contango gets much worse. This is:


This type of contango is a recipe for a total breakdown of a long-term calendar. This is because any increase in implied volatility in whatever underlying the trader might want to trade will only be felt in near-term months. There may be some opportunities in one-month time spreads, but the long-term stuff is scary bad looking. Basically, given the choice between cash and long-term calendars, the decision is easy.

Avoid the long-term calendar spread trade.

By Mark Sebastian of OptionPit.com

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