Advanced Calendar Spread Trades

08/07/2012 7:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Dan Passarelli explains the pros and cons of this strategy, with an eye on what to watch out for.

Calendar spreads offer option traders a way to generate income with the functionality of short options, while providing some protection against directional movement.

This is a function of the disparity in which options of different time horizons decay. Options with less time until expiration lose their value at a faster rate than their longer-term counterparts. But calendar spreads also provide a way to speculate on perceived implied volatility disparities.

Calendar Spreads and Implied Volatility
Traders with a competency of options education may sometimes trade a calendar spread to profit from disparities in the volatility levels between different contract months.

For example, if the June is trading at a 28% implied volatility and the September is trading at a 22% implied volatility, a trader may be able to profit from buying the month with the lower volatility and selling the month with the higher volatility. The goal is to watch the two months volatilities converge.

There are times when this strategy can be used very effectively; but there's no guarantee. There are a few important concepts to consider before trading volatility time spreads.

Implied Volatility
Implied volatility is the volatility component of an option's price. In general, implied volatility is the market's perception of future volatility in the underlying security.

When the future volatility of a stock is expected to be high, traders tend to buy options to hedge their positions or speculate on price swings. This increased demand drives option prices higher. When future volatility is expected to be low, traders tend to sell options, forcing prices lower.

Trading Implied Volatility with Calendar Spreads
If, for example, the implied volatility of short-term-month options on a particular stock are significantly higher than the long-term month's implied volatility, there may be an opportunity to buy a calendar spread. The trader can sell the more expensive, short-term option and buy the cheaper long-term option.

This is the classic buy-low-sell-high strategy-just simply implemented at the same time, as part of a single trade. When all goes as planned, this trade can have profitable results as the volatility of the two months converge.

But be careful! Sometimes there is a fundamental reason why two months have a differing implied volatility. If there is expected news during the life of the (higher priced) short-term month, but none following its expiration, during the life of the (cheaper) long-term month, the trade can fail, as volatile stock movement can thwart profitability.

Another thing to keep in mind is that when a trader buys a calendar spread, the position has positive vega. This means a decrease in implied volatility hurts the position. If the hope is to watch the two months implied volatilities converge, either the long-term month needs to rise to meet the short-term month, or in the case of falling volatility, the short-term month needs to fall at least as much as the long-term month falls.

Dan Passarelli can be found at MarketTaker.com.

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