One of the advantages that options offer is the potential to profit in upward, downward, or range bound markets. Even in quiet markets where low implied volatility is keeping option prices stagnant, potential opportunities can be found.
Recently, volatility has been painfully muted. The CBOE Market Volatility Index (VIX ), the market’s so-called “fear index” has been hovering around its lowest level in 20 years. So what better time to spotlight a low volatility options strategy than right now? And that is, the Calendar Spread. I’ll walk you through the basics here, and then Kevin Hincks and I will demonstrate trading calendar spreads on the live markets in next week’s educational Swim Lessons^{SM} show, next Wednesday, March 22^{nd} at 10:30 CT in the thinkorswim platform.
Calendar Spreads: The Basics
A calendar spread is the sale of a short-term option along with the purchase of a longer-term option of the same type and strike. A calendar is a risk-defined strategy. The risk is typically limited to the amount you paid for the spread, or the debit.
The idea here is that, as time passes, the short-term option sold will decay faster than the longer-term option, and the trade might profit if the spread can be sold for more than you paid for it.
Before we get ahead of ourselves, let's back up and take a look at how option prices respond to changes in the price and implied volatility of the underlying, and with the passage of time.
Calendar Spreads: The Greeks
If you're a regular follower of Swim Lessons, you know we talk at length about the Greeks. No, not Zeus, Hera and Apollo, but rather Delta, Gamma, Theta and Vega. These Greeks measure an option’s sensitivity to various factors that can affect its price. To fully appreciate the value of calendar spreads, traders should have at least a basic understanding of Delta, Theta, and Vega.
Delta is a measure of an option's sensitivity to changes in the price of the underlying stock. For every $1 move in the stock price, the option's price changes by the Delta amount. For example, suppose a stock is trading at $50, and the 50 strike call is worth $2 with a .5 Delta. If the stock were to reach to $51, all else equal, the call would have a new theoretical value of $2.50.
Vega measures an option's sensitivity to changes in underlying volatility, and is generally quoted in terms of a 1% change in volatility. For example, if an option has a Vega of 0.04, a 1% increase in volatility would theoretically increase the option's premium by $0.04, all else held equal. In general, the more time an option has until it expires, the higher its Vega.
Theta, also known as "time decay," is a measure of an option’s price sensitivity to time. The price of an option, also known as the “premium”, is made up of intrinsic (the positive difference between the strike price of the option and the price of the underlying stock) and extrinsic value (time value). Theta estimates how much the theoretical value of the option declines each day. The Theta of a short-term option decays more rapidly than long-term options. This is very important to understand when discussing calendar spreads.
Now...Back to the Show
OK; where were we? Ah, yes; buying a calendar spread. Figure 1 shows a typical options grid, and as an example we've highlighted the April and June 185 strike calls. Suppose an options trader were to buy June 185 call and sell the April 185 call at the middle of its combined bid-ask price of $1.33 (times the contract multiplier of 100) for $133 plus transaction costs. Note the following Greeks:
| Option | Delta | Theta | Vega |
Short | Apr 185 Call | .22 | -.04 | .17 |
Long | Jun 185 Call | .29 | -.02 | .31 |
Here’s how the Greeks can help us interpret the effect of time and volatility on the option spread’s value:
- The spread’s Delta is .07 (.29 minus .22=.07).since the Delta is positive, it means the spread will increase in value as the underlying stock price increases, all else held equal
- The spread’s Theta is .02 (-.04 minus -.02 = -.02), so the spread would theoretically gain $0.02 per day.
- The spread’s Vega is .13 (.31 minus .18 = .13), so the spread’s value would rise $0.13 if volatility were to rise just 1%.
What’s Our Objective Here?
With the above trade, we are looking for the stock price to close near the 185 strike at the April expiration, but preferably below it, so the April option (the short leg) would expire worthless. The credit we receive for the April call helps offset some of the cost of the June option (the long leg). Also, because the spread has a positive vega, we’re also looking for a possible rise in volatility. This is why calendar spreads can be effective in low-volatility environments.
In next week’s column, we’ll roll up our sleeves and explain all the components of this calendar spread.
And join us in Swim Lessons for a live broadcast on Calendar Spreads and Low Volatility Markets on Wednesday March 22^{nd} at 10:30 AM CT.
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