Selection trading strategies offer traders and investors the opportunity to profit in ways not available to those who only buy or sell vest-pocket the underlying security. One such strategy is known as the “calendar spread,” sometimes referred to as a “time spread.” When joined using near or at-the-money options, a calendar spread allows traders to profit if the underlying security remains extent unchanged for a period of time. This is also referred to as a “neutral” strategy.
When entering into a calendar spread, it is momentous to consider the current and future anticipated level of implied volatility. Before discussing the implications of changes in implied volatility on a diary spread, let’s first look at how a calendar spread works and what exactly implied volatility is.
The Calendar Spread
Inscribing into a calendar spread simply involves buying a call or put option for an expiration month that’s further out while simultaneously shop a call or put option for a closer expiration month. In other words, a trader would sell an option that finishes in February and simultaneously buy an option that expires in March or April or some other future month. This traffic typically makes money by virtue of the fact that the option sold has a higher theta value than the opportunity bought, which means that it will experience time decay much more rapidly than the recourse bought.
However, there is another factor that can profoundly affect this trade, and that relates to the Greek changeable vega, which indicates how much value an option will gain or lose due to a 1% rise in volatility. A longer-term choice will always have a higher vega than a shorter-term option with the same strike price. As a effect, with a calendar spread, the option purchased will always fluctuate more widely in price as a result of modifications in volatility. This can have profound implications for a calendar spread. In Figure 1, we see the risk curves for a typical “pale” calendar spread, which will make money as long as the underlying security remains within a particular prize range.
Source: Optionetics Platinum
At the present mean volatility level (of around 36% for the option sold and 34% for the option bought), the breakeven prices for this case trade are $194 and $229. In other words, as long as the underlying stock is between $194 a share and $229 a share in at the time the shorter-term option expires (and assuming no changes in implied volatility), this trade will show a profit. Too, barring any changes in volatility, the maximum profit potential for this trade is $661. This will only crop up if the stock happens to close exactly at the strike price for both options at the close of trading on the day that the option traded expires.
The Effect of Changes in Implied Volatility
Now let’s consider the effect of changes in implied volatility levels on this prototype calendar spread. If volatility levels rise after the trade is entered, these risk curves will sell to higher ground—and the breakeven points will widen—as a result of the fact that the purchased option will addition in price more than the option that was sold. This occurs as a function of volatility. This phenomenon is occasionally referred to as the “volatility rush.” This effect can be viewed in Figure 2 and assumes that implied volatility rises 10%.
Source: Optionetics Platinum
After this higher volatility straightforward, the breakeven prices are now $185 and $242 and the maximum profit potential is $998. This is due solely to the fact that the escalating in implied volatility caused the longer-term option that was purchased to rise more than the price of the shorter-term alternative that was sold. As a result, it makes sense to enter into a calendar spread when the implied volatility for the way outs on the underlying security is toward the low end of its own historical range. This allows a trader to enter the trade at a lower cost and offers the potential for greater profit if volatility subsequently rises.
On the other end of the spectrum, what traders need to also be in the know of is the potential for something known as the “volatility crush.” This occurs when implied volatility falls after the dealings is entered. In this case, the option purchased loses more value than the option sold simply due to its heinous vega. A volatility crush forces the risk curves to lower ground and greatly shrinks the distance between the two breakeven points, as a result reducing the probability of profit on the trade. The other piece of bad news is that the only defense for the trader in this turns out that generally is to exit the trade, potentially at a loss. The negative impact of a decline in volatility on the profit potential for our example almanac spread trade appears in Figure 3.
Source: Optionetics Platinum
Following this decline in implied volatility, the breakeven price range for this occupation has narrowed to the $203 to $218 price range, and the maximum profit potential has dropped to just $334.
Figure 4 summarizes the impressions of changes in implied volatility for this example trade.
| Implied Volatility Level | Lower Breakeven Price | Wealthy Breakeven Price | Profit Range | Maximum $ Profit |
| 24% | $203 | $218 | $15 | $334 |
| 34% | $194 | $229 | $35 | $631 |
| 44% | $185 | $242 | $57 | $998 |
The Prat Line
A calendar spread is an option trading strategy that makes it possible for a trader to enter into a deal with a high probability of profit and a very favorable reward-to-risk ratio. As with all things, however, there is no disenthrall lunch. And in this case, what you see may not be exactly what you get. While the risk curves for a calendar spread may look lead oning at the time the trade is being considered, a trader needs to carefully assess the present level of implied volatility for the privileges on the underlying security to determine whether the present level is high or low historically. Likewise, the trend of implied volatility is high-ranking. If volatility is expected to rise, the prospects for a positive outcome are much greater than if volatility is trending sharply reduce.
As with most everything that you buy and sell, it is extremely important to know if you are paying or receiving a lot or a little. When it criticizes to option trading, the tool to use to make this determination is the variable known as implied volatility. If IV is high, the odds favor those who detract options, or sell premium. When IV is low, the odds favor those buy premium. Ignoring this critical piece of intelligence is one of the biggest mistakes any option trader can make.