I was recently looking at calendars with an option-mentoring student who was looking at various option trading strategies. We noticed something interesting; it appears that calendars are starting to fall into some sort of line. As in, I can see a possibility of not hating time spreads sometime in the near future. Here’s why…
If anyone read my first piece for Stocks Futures and Options Magazine titled “How Well Do You Know Your Vega," I talk about the subject of the option Greek “weighted Vega.” This is a very important thing to understand because it is at the crux of how calendars make money. Basically, when one buys a calendar, there are many times where a trade might be long “raw” Vega, but not long “weighted” Vega. Meaning, when taking into account how quickly the front month moves relative to the back month, the Vega is actually negative. Why is this important?
Over the last couple of years, the only times where it has seemed favorable to get long calendars has been when the market has fallen quickly and front-month implied volatility (IV) has popped. This is because SPX back-month volumes have been so much higher than front-month volumes. This is actually the root cause of all that VIX contango that our good pal Bill Luby likes to write about. Looking at the volumes, the SPX IV has been much higher than front month IV for a long time. Here is an image of what the front three months looked like at the beginning of the month. Notice how much higher November was than October.
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Why am I pointing it out? For the first time in some time, the SPX first and second months are actually somewhat in line (January is still much higher). Instead of the front month popping, the back month has actually fallen into line. This could create a very favorable trade if this trend continues. If December continues to get pounded, I may put the green light on for long calendars for the first time in a long time. Long story short, it appears that the first and second month may better correlate than they have over the last few years. Here is a look at today; notice how the curves have tightened:
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I want December to fall a touch more, but this term structure is not nearly as bad as what we have seen over the last two years. (Want to know more? Check out the AM Pit Report (at OptionPit.com), done LIVE every day at 9:50 am ET. It’s like a mini-Webinar, where traders can watch a professional trader trade live!) There are a large amount of favorable trades starting to form for income traders. Could this be the return to good times? We shall see!
By Mark Sebastian of OptionPit.comMark Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange and can be found at OptionPit.com.
