Ask most option traders, and they’ll say that if the markets are trending distinctively in a given direction, long calls and puts might provide desirable returns relative to risk. On the other hand, when markets start to trend sideways, selling options might be more desirable to some traders. But markets don’t always behave.
As stocks rise and fall, option volatility tends to follow equity moves in the opposite direction. Although volatility generally takes its sweet time to move lower, it’s also been known to rise quickly or spike unexpectedly. That’s when the long calendar spread can come in handy. Long calendar spreads are designed to hedge for volatility risk, especially to navigate earnings season or other corporate news events that can poke a stock into action.
Figure 1 shows a seasonality chart for the CBOE Volatility Index (VIX) in the first two months of 2015. You can see that after the holidays—traditionally a low-volatility time of year—were over, the VIX rallied roughly 10% though January and February. Such a sizable move could hurt options sellers, who look for volatility to drop.
How Does It Work?
Long calendar spreads are a combination of short options with a shorter expiration and a long option at the same strike price with a longer expiration. Because the long option has more time left, it will have more extrinsic, or “time,” value. This is the portion of an option’s price that is affected directly by volatility changes. The long option benefits from rising volatility. And since it has more time value, the spread as a whole will tend to benefit from rising volatility.
It’s also noteworthy in our sample scenario that the end of December represents the end of the fourth quarter. That means that earnings season typically is in full swing. Constructing long calendar spreads can help traders manage risk in an active trading portfolio during this potentially volatile period for trading stocks.
Of course, not all volatility levels move at the same rate or distance. This is called volatility skew. For example, when volatility moves for options in general, options with less time to expiration will tend to experience bigger gains or losses. Because long calendar spreads have two options with different expirations, traders sometimes benefit from volatility skew.
Earnings season is typically a prime time for many stocks to experience skew in their volatility levels across different expirations. Figure 2 shows an options table for stock XYZ in the lead-up to an earnings announcement. Notice that its volatility levels are higher for closer expirations than the longer expirations. This makes sense. If the stock experiences a big, unexpected move, there is more time for the longer expirations to recover. That means their options will be less expensive. On the other hand, options that expire close to the earnings announcement will have less time to recover, which makes their options potentially very expensive.
No Free Lunch
Imagine being able to buy a really cheap option for a stock that could (emphasis: could) make a big move. That would represent a potentially attractive reward-to-risk scenario for skilled traders. Market makers—those firms paid to create volume in certain stocks and options—compensate for this by raising prices. Typically, options sellers love higher premiums. But the reason for the higher premiums is higher expected volatility in the stock price. That can potentially be detrimental to an option seller who has limited reward if the stock moves in their direction but can experience bigger losses if it moves away.
Enter long calendar spreads, which allow traders to trade two options simultaneously. Let’s use XYZ again. Figure 3 shows a chart of the underlying stock. You can see that the stock has been on a steady uptrend for most of the past year. Also, the stock has responded positively to each of its past four earnings reports. Knowing this, a trader might sell a more expensive put (a bullish trade) and buy a cheaper put in case the stock makes an unexpected move lower.
Now, think of a balloon popping. Once earnings figures are out there for everyone to chew over, there isn’t as much risk of unexpected moves. That means volatility will tend to drop sharply—like air being let out rapidly from a popped balloon.
Remember, options with shorter expirations experience bigger swings in volatility. So, once company XYZ announces its results, the trader is guessing not only that volatility will fall, but that it will fall more sharply in the shorter expiration option than the option with more time to soak up the underlying stock move.
Figure 4 shows two options that can be used to construct a long calendar spread. Notice that the option with only 13 days to expiration has a higher implied volatility. If you were to sell it, you would profit from a decline in volatility, which you expect to drop fast after earnings is released. The long option has a lower level of volatility, so it doesn’t have as much room to fall. It can also protect you if the stock were to drop sharply toward the strike price.
With volatility levels expected to rise according to seasonal patterns over the next few months and another earnings season set to begin in the middle of January, there could be plenty of opportunities for option sellers to use long calendar spreads. It’s a strategy that helps to hedge risk in potential volatility gains and leverages volatility skew for short-term opportunities surrounding earnings announcements.