Fri, Sep 12, 2008 | Jared Woodard
Since our last Calendar Options bonus trade, we’ve been focusing on preparing the new site and the official launch of the Calendar Options subscription service—our non-directional approach to using calendar spreads as an income-generating strategy. But there’s another important reason we haven’t published a calendar-spread bonus trade since the July options cycle: volatility risk.
The Calendar Options strategy complements our iron condors because each offsets the volatility risk of the other. But unlike an iron condor, a calendar spread’s profit curve at expiration varies with implied volatility. Volatility may affect the profit we’re able to lock in from an iron condor at a particular time during the life of the trade, but once expiration rolls around, as long as we’re comfortably out of the money, the impact of volatility becomes negligible.
With calendar spreads, on the other hand, our profit upon the expiration of the short leg depends on the value of the longer-dated option—which depends on the implied volatility of that option. While we may benefit from an increase in IV, a significant drop in volatility can drastically reduce the value of our position at expiration, and narrow our breakevens to the point where the probability of ending up with a profit is, as the simulation pictured above shows, none too attractive. Therefore, we avoid entering calendar spreads when the implied volatility is too high.
To see where you’re going, look at where you’ve been
So how high is “too high”? That can be a tough question to answer with great certainty, but it’s fairly safe to say that if the options we’re buying have an implied volatility near the bottom of the 12-month range of IV for options on the underlying stock, our volatility risk is relatively low. Conversely, if we’re buying volatility (which effectively is what we’re doing when we buy a calendar spread) near the top of that 12-month range, we’re practically inviting the seller to take us to the cleaners.
It takes just a quick look at the one-year chart of the VIX to see why the August expiration cycle was hardly ideal for trading calendar spreads. We like to open Calendar Options trades between about 25 and 35 days before front-month expiration—which for August would have been coming off the volatility spike at the July market low. With volatility relatively high and clearly in a downtrend, good trades were hard to find, especially when we combined volatility with our other criteria.
The post-Labor Day sell-off puts us in a challenging environment once again. Nevertheless, a high VIX doesn’t necessarily mean that no ETF or individual stock can present us with a reasonable Calendar Options opportunity.
Over the coming weeks, we’ll be looking for October calendar spreads that fit our risk/reward criteria and hope to come up with at least a couple of promising trades. Subscribers to the Calendar Options service will instantly be notified by e-mail when we place an order, and of all follow-up actions we take through the duration of the trade. Plus, we’ll regularly post subscribers-only analysis of the market and our positions. Look for an update regarding the status of the Calendar Options subscriber service early next week. If you’re interested in becoming a subscriber and haven’t already let us know, check out our September 5 post.