Time for a pop quiz.
Q: When is a volatility trade not about volatility?
A: When it's a calendar spread.
Typically, traders think about two things when you mention calendar spreads: sideways trends and low volatility ("vol"). Also known as “time spreads,” calendars have been popular in the past year due to the low volatility backdrop. Now, advanced traders have learned that long calendars have positive vega (i.e., buying volatility), and that lower volatility typically means lower-priced calendars. But what they haven't learned is that an increase in volatility won't necessarily save a calendar gone bad. And when it comes to calendars, vol might not be telling them what they think they hear.
Let's Back Up
Calendars are designed to profit from the passing of time, not a stock's movement. So generally, you want the underlying to trade in a relatively flat range over the life of the trade. As in other range trades, the zone of potential profit generally looks like a “tent” in the risk/reward profile (Figure 1).
Calendars are created using any two options of the same stock, strike and type (either two calls or two puts), but with different expirations. For example, if stock XYZ is $50, and you think it will trade in a tight range around $50 for a while, you might buy one July $50 call for $2.00 and sell one June $50 call for $1.25-also your max risk. You'd then own a long June /July calendar for $0.75 debit (not including commissions and fees).
How do you profit? If as expected, the shorter-term option decays at a faster rate than the longer-term option, the spread “widens” and you may be able to close out the spread for a profit. All things being equal, were XYZ to finish at $50 at expiration of the short option, your short option would be worth zero while the long option might now be $1.25. Since your long spread has “widened” from 0.$75 to $1.25, your profit is $0.50 (less commissions and fees). It's not always this perfect, but you get the idea.
Several different options strategies give you that “tent” risk/reward profile that may profit from a stock price landing in a range by expiration. Butterfly spreads, short straddles, and calendars (Figure 1) are designed to maximize their profits when the stock is right at the short strike price. Of those three strategies, only calendars can look more attractive when vol is low. In that environment, long butterflies are theoretically more expensive and short straddles have lower credits.
Using calendars in your strategy is more than knowing that you're buying and selling options in different expirations, and looking for low volatility, or certain intermonth vol differentials. Low vol doesn't automatically mean long calendars are good opportunities. And volatility isn't the whole story behind them. Let's go beyond the basics, and talk about tools that can help.
Rolling: The Secret Sauce
While calendars are an essential building block to spread trading, if you're trading them by themselves, their profit potential may increase with “rolling.” The roll is buying back the short front-month option, and shorting the same strike option in the next expiration. Because the option with more time to expiration has greater extrinsic value, the roll should generate a credit of some amount. Buying a calendar incurs a debit, and the credits from the roll(s) have to be at least as large as the debit. If the rolls aren't high enough to cover the debit and transaction costs for buying the calendar, the trade won't make money. Consider the value of the roll and three of its various moving parts.
Time to expiration: When you decide to roll is the only aspect you can control. All things being equal, a roll will achieve its maximum credit when the short option is almost fully expired. This makes sense because time decay is reducing the extrinsic value of the option most quickly approaching expiration. And you buy the short option back for almost zero extrinsic value, and take in the extrinsic value of the next-month option as credit. The less you have to pay to buy the short option back, the better.
So, why wouldn't you just let every calendar go to expiration? Because the stock price and volatility may be at better levels for the roll before expiration, and waiting until expiration means you're risking the stock moving away from the strike price and/or volatility shifting.
Volatility: While volatility is something you can't control, you can have an idea of what might cause it to go higher or lower. When uncertainty in the market is high, implied vol (the market's future price projection of the stock, as priced in the options) can be high. When there's more complacency, implied vol can be lower.
So, you'll often see implied vol rise ahead of news or earnings announcements when there is uncertainty about how they might impact the price of the stock. Implied vol often drops right after the announcement when the news is out and digested, and the uncertainty subsides. This is tied to options expirations cycles, when news scheduled after an expiration does not affect the implied vol of the options in that expiration. The news will likely have a greater impact on the volatility of the options that expire in the nearest expiration after the news. Which is why you'll see different implied volatilities—and thus, different roll values—in options with different expirations.
This is important because as the front month expiration approaches, the value of the roll depends a lot more on the vol of the back-month option, the one you're rolling the short front-month option to. That's because the vega (a measure of an option's sensitivity to changes in the volatility of the underlying asset) of that back-month option is higher than the vega of the front-month option, and why changes in the implied vol of the back-month option can have a much bigger impact on the value of the roll than changes in the vol of the front-month option.
Pay closer attention to that back-month option's volatility. If it moves higher, or you believe it might move higher because of news that would impact options in that expiration, you may get more credit for the roll. Alternatively, if vol has dropped in that back-month option, its value will probably have dropped more than the front-month option. This is also important when initiating calendar trades. More later.
Stock price: Where the stock is, in relation to the strike price, either close to it or further away, usually has a bigger impact on the roll value than either the approach of expiration, or volatility. For a given number of days to expiration and volatility, the roll value is going to be maximized when the stock is very close to the strike of the calendar. That's because the at-the-money option has the highest extrinsic value, regardless of its expiration. You'll see calendar spreads/roll values peak at the at-the-money strike. As you watch successive out-of-the-money strikes, the calendars/rolls are worth less. This is more pronounced close to expiration. If the stock is close to the strike price in the days before expiration, that could be the most opportune time to roll, and you don't want to lose it if the stock moves from the strike.
You can see this on the thinkorswim® platform. On the Trade tab, load up the “Calendars” from the Spread dropdown menu and select “Mark” as a column choice. You'll see the prices of the calendars for adjacent months. It doesn't matter which months are available. Calendars are most valuable for the at-the-money strikes, and the values fall away more quickly from the at-the-money the closer the options are to expiration. For the calendars in further months, the drop from the at-the-money is shallower. The difference in the value of the calendars reveal how much value the roll might lose if the stock moves away from the strike price.
Rolling It All Together
OK. So you understand how rolls are affected by time, vol, and stock price. And you know that credits from the rolls are key to profits in calendars. But how do you put it together to find a potential calendar-spread trading opportunity?
First: consider the option price, as well as its implied vol. Don't get suckered by high front-month vol in a wide, intermonth vol skew—vol levels of the same strike with different expirations—that doesn't give you much premium for the short option. When building a calendar, start by looking for the short front-month option. I start with the options that have between 25 and 35 days to expiration, and I look at the strikes that are 2 to 4 strikes out of the money. That may help to balance the probability of an option expiring worthless, time decay, and actual option premium.
Then, look at the next consecutive expiration for the long option. If the debit of the calendar is less than, or about equal to, the price of the short front-month option, it may be a calendar to consider further.
Second: consider if you can break even on the calendar if the stock doesn't move in the right direction. Calendars are directional to the extent that the strike is at, or away from, the money. Remember that the calendar/roll maximizes its value when the stock is at the strike price. So, a put calendar at a strike below the current stock price is bearish, and a call calendar at a strike above the current stock price is bullish.
But I like to find calendars that have a chance at even a small profit if the stock stays where it is, or even moves away from the strike. That's related to the first step. Why? At the time the short front-month option is approaching expiration, the long back-month option will have about the same number of days to expiration that the short front-month option has now—about 30. So, the price of the short front-month option can be used to approximate the price of the calendar/roll in one month. With the price of the front-month short option at least as high as the debit of the calendar, it's possible for the calendar to be profitable, even if the stock stays at its current price until expiration.
Go one step further by looking at the successive out-of-the-money, front-month options. Those indicate the price of the calendar/roll if the stock moves away from the calendar's strike by that many points. So, if the stock is at $50 and the 48 put is .60 and the 47 call is .50, the calendar roll might be worth .60 if the stock stays at $50, or .50 if the stock moves up to $51.
Third: realize your potential. Make sure you get a high enough potential profit if you're right, and the stock does move to the calendar's strike price. Look at the current at-the-money option in the same expiration as the short option of the calendar. That's the approximate value of the calendar/roll if the stock is close to the strike price near the front-month expiration. If the price of that option is only slightly higher than the calendar debit, the potential profit wouldn't be that high, compared to the risk I'm taking on the calendar. I like the potential profit to be at least as great as the risk—defined as the debit of the calendar, and preferably about 1.5x greater than the risk.
This approach to calendar spreads is price-based. Don't ignore implied volatility. But, look at the overall implied vol difference between expirations as a place to begin looking for price-based calendars. But not as the sole criterion. When the front-month implied vol is slightly higher than the back-month vol, calendars tend to meet the price criteria I want. When the back-month vol is higher, it's tougher to find them. And when the front-month vol is much higher, that can indicate large potential price swings in the stock price that could drive it away from the calendar's strike.
If you decide to use calendars in your portfolio, use the functionality available in the thinkorswim platform to make the job easier—from checking vol differentials and prices, to roll values and trade entry.