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Options Theory: Meet the Calendar Spread

August 16, 2018

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Think about the everyday cash flow trader’s toolbox. What are his top five strategies? If you answered covered calls, naked puts, bull puts, bear calls, and iron condors, then pat yourself on the back. You’re officially well versed on the option selling business. Do you know what each one of these has in common?

They’re positive theta.

Duh. That’s the easy one. All cash flow trades profit from time decay. What else do they have in common?

They’re all negative vega. That’s pro speak for short volatility which means they profit from a drop in implied volatility (IV). And since IV is mean reverting it’s most likely to drop when it is high.

So the top five cash flow strategies are all more attractive in high IV environments. As a side note, I use the mighty implied volatility rank  indicator and would consider anything with an IV rank above 50% as “high.”

And now we arrive at the tantalizing question for today’s post.

What does a cash flow trader do in low IV environments?

I have two answers.

First. Don’t change anything. Keep doing your typical strategies and simply accept the lower premiums that you’re being paid. The market is probably slow moving and the risk of a big adverse move is diminished so you don’t deserve to be paid as much.

So stop complaining.

Second. Consider cash flow strategies that are more attractive in low IV environments. They are known as calendar spreads.

Legacy students will recall these unique strategies are taught in the Options II course. For everyone else, allow me to introduce you.

Calendars involve buying long-term options while selling short-term options. Suppose we have a $200 stock.

A put calendar might consist of buying a two-month $200 put and selling a one-month $200 put. Right now that would be buying Oct and selling Sep.

A call calendar might consist of buying an Oct $200 call while selling a Sep $200 call.

These examples involved buying and selling the same strike and are known as horizontal calendars. Another variation exists where you buy and sell different strikes and is known as a diagonal calendar.

Since long-term options have a higher sensitivity to volatility, the trade is positive vega. This is a key point! You capture positive theta with this type of trade but unlike every other cash flow trade, this one is better suited for low IV environments.

The risk graph of a calendar looks like a tent where the profit zone peaks at the short strike. In the $200 calendars mentioned above we would be shooting for the stock to sit near $200 at expiration. If I thought the $200 stock was going to rise toward $205 then I would want to establish my calendar with the short strike at $205.

This is what the risk graph looks like:

If the stock moves outside of the tent then we can widen it! Just add another tentpole like so:

Mastering the dynamics of a calendar spread is outside the scope of a single blog post, but I wanted to put it on your radar as a topic worth pursuing. I use calendars frequently in low volatility environments when verticals are no longer appealing.

For example, if a stock is oversold and due to pause for a few weeks I would typically consider entering an iron condor. But if implied volatility is too low then I’ll do calendar spreads instead.

Furthermore, I’ve discovered that slightly OTM put calendars work really well with stocks that are overbought with low implied volatility. Normally that’s a setup I wouldn’t trade.

Learning a new strategy opened me up to adding a new tradable setup to my playbook. That increases the number of trades I can do and thus the money I can make. You’ll see me highlight calendars from time to time in the weekend Options Report.


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3 Replies to “Options Theory: Meet the Calendar Spread”

  1. Avatar ROBERTMCKEE says:

    Thanks Tyler! Yes it’s been difficult to find good candidates for traditional theta trades with high IV that don’t have earnings on the horizon. My calendar spreads have worked better for me recently and now I know why!

    1. Tyler Craig Tyler Craig says:

      Glad to hear it, Robert!

  2. Avatar AbidRahnaman says:

    Great read, thanks Tyler!

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