Singing the Low-Volatility Blues? Try Calendar Spreads

One of the advantages that options strategies 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.

Over the last several years, the stock market has seen periods of low volatility. In 2017 and 2018, for example, the Cboe Volatility Index (VIX ), the market’s so-called “fear index,” touched its lowest levels in 20 years. One options strategy to consider during periods of muted vol is the calendar spread (“calendar”).

Calendar Strategy Basics

A calendar is the sale of a short-term option along with the purchase of a longer-term option of the same type and strike. It’s a defined-risk strategy, with the risk 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.

Understanding 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 0.5 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 value (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 essential to understand when discussing calendars.

The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.

Strategy Example: Long Call Calendar 

Figure 1 shows a typical options chain, and as an example, we've highlighted the November (Nov) and December (Dec) 235-strike calls. Suppose an option trader were to buy a Dec 235 call at the offer price of $5.90 and sell a Nov 235 call at the bid price of $3.70 (times the contract multiplier of 100), or ($5.90 - $3.70) x 100 = $220 plus transaction costs. Note the greeks in the table below:

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 0.05 (0.35 minus 0.30= 0.05). Since the delta is positive, it means the spread will increase in theoretical value as the underlying stock price increases, all else held equal.
• The spread’s theta is 0.02 (-0.07 minus -0.09 = 0.02), so the spread would theoretically gain $0.02 per day.
• The spread’s vega is 0.12 (0.37 minus 0.25 = 0.12), so the spread’s value would rise $0.12 if volatility were to rise just 1%.

What’s Our Objective Here?

With this spread example, we’re looking for the stock price to close near the 235 strike at the Nov expiration, but preferably below it, so the Nov option (the short leg) would expire worthless. The credit we receive for the Dec call helps offset some of the cost of the Nov option (the long leg). And because the spread has a positive vega, we’re also looking for a possible rise in volatility. This is why calendars can be effective in low-volatility environments. 

Note that the same logic applies to put calendar spreads as well. All else equal, a calendar's profit potential peaks with the underlying stock at the strike price upon the expiration of the front leg. See figure 2. Remember, though, that an option can be exercised at any point prior to expiration, so if you plan to hold a calendar spread up to the front-month expiration, it's important to understand the ins and outs of option expiration.

The Forces of Volatility and Time

One of the advantages of calendars 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’re 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 an increase in volatility (vega), or the passage of time (theta).

Remember, the spread’s theta is 0.02 (-0.09 minus -0.07 = -0.02), 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 Nov option helps offset some of the cost of the long Dec option—until the Nov option loses its extrinsic value. Refer to figure 2 to see the spread’s value today (purple line) and at Nov expiration (blue line) graphed to movement in the underlying stock. Note that, as Nov expiration approaches, the purple line slowly converges to the blue line.

On the thinkorswim platform from TD Ameritrade you can model this movement by right-clicking on a trade and selecting Analyze > Risk Profile. In between the order ticket and the graph, next to the date, you'll see a "+" sign. Selecting that rolls the risk analyzer to the next day. Do it again several times and watch the lines converge.

And let’s not forget the effects of volatility. Figure 3 shows the change in the spread’s theoretical value with a 5% rise in volatility. The vega of the spread is 0.12. Raising volatility 5% in the risk analyzer, and keeping all else equal, brings the theoretical value up by roughly ($0.12 x 5 x the multiplier of 100), or about $60.

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’d 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.  

Markets are dynamic: There are active periods and slow periods, high volatility and low volatility. If you’re an options trader who occasionally sings the low-vol blues, consider taking a look at calendar spreads to help you find the right note.