One of my favorite option spread strategies especially for longer term trades within my trading systems is the calendar spread (or time spread). As you probably know, the long calendar spread consists of selling an option in one month (typically the front month) and buying an option at the same strike and of the same type (put or call) in a month that is further away. These spreads are typically considered "neutral" because you are long and short the same strike price but in different months. Essentially you want the stock to stay within a range and let theta work its magic. When the short call expires worthless, you can keep the premium and sell the long call back. Easy peasy.
Actually, it's not as easy as it sounds. What they don't mention is that calendars are highly susceptible to changes in volatility (vega). It's also rarely mentioned that calendars can also be used as directional plays much like speculative butterflies. And finally, another catch to the calendar spread is that if the underlying moves very quickly towards your profit target, the profit is less than if it took its time. Since calendars are also theta plays, if you're wrong about the time, you're not making all you can from a favorable move in the underlying.
In the trading system that I use with real money, my watchlist consists of stocks with relatively low beta. A calendar makes a lot of sense in this situation since it will typically take low vol stocks a longer period of time to move where I want them to. Also with low vol stocks, the chance of wild spikes in volatility is lessened. With a speculative calendar spread, a rise in volatility is favorable, in other words, you're long vega.
I recently closed a speculative calendar spread on MSFT. My speculation was that MSFT was at the top end of a long standing trading range. I was bearish on MSFT and opened a put calendar spread at the $27.50 strikes. I'd like to outline the pros and cons of the trade and why I would not open the same trade today. I opened this bearish trade at the beginning of May. Let's take a look at the implied volatility.
Notice at the end of April, there was a nice drop in implied volatility. MSFT was also near the top of its trading range. I opened the spread when MSFT was a bit below $31. My speculation was that MSFT could see $27.50-$28.00 within the next 3 months so I sold a JUL 27.50 put and bought an OCT 27.50 put. Thanks to
penny spreads, I believe the total bid/ask spread was $0.03. I closed this spread at a profit of about 50% on 6/29/2007 upon the penetration of the lower Bollinger band and a rise in implied volatility. The three things I speculated on were all favorable. The move in the underlying, rise in volatility and time had passed.
So whoop-dee-doo, everything turned out in my favor. It doesn't always work out that way (I'll get to some bad trades soon). But let's see what could've happened. Let's take the same trade today (except we'll go short the AUG puts and long the OCT puts). First, let's say that MSFT moved rapidly to our strikes (which is our mental profit target).
(Note: click thumbnails for full sized image)
You can see here that if MSFT moved to my short strike in a day, my profit is a measly 9 bucks. Hardly a king's ransom for being so right. If the same move happens over 30 days, my profit is $30. If you notice, my total investment here is $25, so that is a profit of over 100%. But the key here is that I must be right on theta.
Now I'll demonstrate the other kicker, I must also be right on vega. Let's see how a change in implied volatility will change the P/L of this position.
Current volatility is ~23%. For this time horizon, I'd say that this IV reading is about the middle of the range. The image above (click to enlarge) demonstrates what happens to our position when volatility changes. Note, I forwarded the date to 30 days from now. As you can see, a stable IV will net us close to our $30 profit, but look how that gets squeezed away very quickly as volatility drops. If IV drops a to 16% which has happened on a few occasions in the last 12 months, we're nearly break-even with only a chance to lose money. Ouch.
So even though this is called a time spread, volatility forecast plays a huge role. This would be main reason for staying out of this trade today. The volatility is not in a place where I think I can make a prediction comfortably.
Calendar spreads are a great way to make a very favorable risk/reward speculative trade, but it's important to understand that price of the underlying is only 1/3 of the bet.
Subscribe