This follow-up article to the introduction of calendar spreads demonstrates how the strategy can be effective in a low-volatility trading environment.
In last week's article, Scott Connor, my Swim LessonsSM co-host introduced the calendar spread, a risk-defined options strategy involving the sale of a short-term option along with the purchase of a longer-term option of the same type and strike. Scott laid out the basics— delta, theta and vega— and explained how they can help us interpret the effects of time and volatility on a calendar spread’s value.
In last week's installment, we bought a hypothetical out-of-the-money call calendar spread, purchasing the June 185 call and selling the April 185 call, at a spread price of ($2.69 - $1.36) = $1.33 (times the contract multiplier of 100), or $133, plus transaction costs. The underlying stock was trading at $176.92 at the time of the trade. Here is a summary of the trade and its risk components:
Apr 185 Call
Jun 185 Call
Figure 1 shows the theoretical payoff of our calendar spread at expiration of the April contract. Notice how it's peaked at the strike price.
FIGURE 1: CALENDAR SPREAD PAYOFF AT FRONT-LEG EXPIRATION
Note the spread's max payoff is right at the strike price at expiration of the April contract. Source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
One of the advantages of calendar spreads, is that you don't need a move in the underlying stock in order to see the spread’s theoretical value rise. Remember, with a long calendar spread, you are positive theta and long vega. This means that even if the underlying stock remains unchanged, the spread’s theoretical value could still rise, either through the increase of volatility (vega), or the passage of time (theta).
Remember, the spread’s theta is .02 (-.04 minus -.02 = -.02), so the spread theoretically gains $0.02 per day (times the contract multiplier of 100, or $2 per day), all else held equal. Another benefit of having positive theta in a calendar spread, is that the premium received for the short April option helps offset some of the cost of the long June option— until the April option loses its extrinsic value. Refer to figure 1 to see the spread's value today (purple line) and at April expiration (blue line) graphed to movement in the underlying stock. Note that, as April expiration approaches, the purple line slowly converges to the blue line.
On the thinkorswim® platform you can model this movement, by right-clicking on a trade, and selecting Analyze > Risk Profile. In between the order ticket and the graph (like the one shown in figure 1), next to the date, you will see a "+" sign. Clicking that rolls the risk analyzer to the next day. Click it several times and watch the lines converge.
And let's not forget the effects of volatility. Figure 2 shows the change in the spread's theoretical value with a 1% rise in volatility. The vega of the spread is 0.13 and, sure enough, raising volatility 1% in the risk analyzer brings the theoretical value up by ($0.13 x the multiplier of 100) = $13.
FIGURE 2: EFFECT OF A 1% RISE IN VOLATILITY.
A 1% rise in volatility, all else being equal, would raise the theoretical price of the spread by $.013, the spread's vega. The platform allows you to experiment with different scenarios such as time, volatility, and you can even view the risk profile should you decide to hang onto the June option after the April expires. Source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The effects of volatility and time on calendar spreads are what might make them effective in a quiet or low-volatility market environment. If the market is at a standstill, the theta is theoretically working in your favor. If the market starts moving, and as a result volatility moves higher, you might stand to benefit from the spread's positive vega. But, as with all options trades, there are risks. If the underlying stock were to move far enough away from the strike, you begin to lose the extrinsic value of the long leg. And just because volatility is low doesn't mean it can't go lower. Vega works both ways.
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Please note that the examples above do not
account for transaction costs or dividends. Transaction costs (commissions and
other fees) are important factors and should be considered when evaluating any
options trade. Transactions cost for
trades placed online at TD Ameritrade are $6.95 for stock orders, $6.95 for
option orders plus a $0.75 fee per contract. Orders placed by other means will
have higher transaction costs. Options exercise and assignment fees are $19.99.
Spreads and other multiple-leg option strategies
can entail substantial transaction costs, including multiple commissions, which
may impact any potential return. These
are advanced option strategies and often involve greater risk, and more complex
risk, than basic options trades.
Market volatility, volume, and system availability may delay account access and trade executions.
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