Condor Options

Like our iron-condor strategy, Calendar Options is a version of techniques used by professional traders to generate income regardless of market direction. It complements the iron-condor portfolio by providing market-neutral trades that can benefit from rising implied volatility.

Calendar Options is a non-directional strategy—i.e., its goal is to produce positive returns whether the market is up, down or flat over the course of a given period (month, quarter, year). The aim of the strategy is to generate income by selling option premium, but instead of taking in the difference in premium between options that are at different strikes, as we do when we sell an iron condor, Calendar Options primarily seeks to exploit the difference in the rate of time-decay between options with different expiration dates.

The figure below illustrates the time decay (average of calls and puts) at various strike prices for S&P500 Index ETF (SPY) options expiring one month apart. The white line plots the theoretical daily change in value for December options, and the orange line shows how much the corresponding January options are expected to lose (note the negative values on the y-axis) over the same time period. The distance between the two lines represents the difference. This snapshot was taken with SPY trading at about $119, which―not co-incidentally―is almost exactly where there’s the greatest difference in time decay.

Time decay for options expiring in December (white) and January (orange).

So if we were to buy the SPY January 119 calls and sell the SPY December 119 calls, we could expect our net return (the amount of time premium we keep) to be about $0.04 per share ($4 per contract), per day―all other factors remaining constant (this is a very important point that I’ll come back to later). The net price for this transaction, at the time the above figure was captured, was about $1.80 per share. That means our expected rate of return is about 2.2% ($0.04 ÷ $1.80) per day,…but, again, that’s the theoretical rate of return, if everything else (share price, implied volatility, interest rates, etc.) stays the same

Of course, everything else does not stay the same even from minute to minute, let alone from week to week. So making money with calendar spreads isn’t just a matter of buying one expiration, selling another one closer in time and waiting for the payout. In the above figure alone, we can see that as the underlying price moves away from the strike price of our SPY Dec/Jan 119 calendar spread, the rate of return drops rapidly and non-linearly (and eventually turns into a net daily loss). And as the profit/loss curve for a typical calendar spread (below) shows, a fall-off in the rate of time-decay isn’t the only thing we have to watch out for.

Profit/Loss profile for single-strike calendar spread, at current date (white) and expiration (red)

Calendar spreads, like other positive-theta option spreads, have negative “gamma”—which is how options geeks like myself say they lose current value, not just theta (daily rate of return), as the underlying share price moves away from the strike price in either direction…and within a certain range, the additional loss for every one-point move in the shares keeps getting larger and larger. This isn’t news to anyone who’s sold an iron condor or bought a butterfly (two other positive-theta strategies popular among option traders), and in that respect calendar spreads are similar to condors and butterflies.

But when it comes to vega—the theoretical change in value for every one-point change in implied volatility—they’re exactly the opposite. Instead of profit increasing when implied volatility falls and coming under pressure when uncertainty grows, like it does with a condor or butterfly, a calendar spread’s P/L curve tends to get a boost when fear sets in, and sink as the market becomes more complacent.

Calendar-spread P/L at expiration, at constant implied volatility (red), higher IV (orange) and lower IV (white).

What’s more, the covering position still has premium value when the short contracts expire in the front month, so changes in implied volatility affect the price we get when we close a calendar spread—in contrast to an iron condor, which ends up with the same profit or loss at expiration, at a given share price, regardless of implied volatility. The above simulation shows how the same calendar-spread position depicted in the previous figure can have a much better, or worse, outcome at expiration depending on whether implied volatility for the back-month options increases (orange line), decreases (white) or stays the same (red).

Now, this doesn’t mean calendar spreads are riskier than condors or butterflies. Each strategy offers a potential return based on it’s level of risk, in terms of both probability and the ratio of risk to reward. The only difference is in their risk profiles—i.e., where those risks lie—and it’s important to trade a variety of strategies in order to diversify the overall risk profile of your portfolio.

So the key to remaining profitable over the long-term isn’t picking the “right” trades, or even so much timing trades perfectly—it’s having a good strategy for risk management, from capital allocation, to trade entries, to planning what you’re going to do if (when) the market goes against you, to knowing when it’s time to take whatever profit (or loss) you have and look for the next opportunity. The Calendar Options strategy primarily focuses on managing risk, starting with capital allocation.

That’s where we’ll pick up in Part II of the Strategy Guide, “Risk Management, Step by Step”.