A Time for Calendar Spreads

The current skew in implied volatility created by the recent sell-off make this the right time for using calendar spreads for downside protection heading into the crucial, and often cruel, October earnings season.

This sets up a situation in which we can create a position that will benefit in three ways:

  • Time decay
  • A decline in price
  • A normalization of the volatility term structure

Calendar spreads are also often referred to as time spreads, to describe a strategy which involves the purchase of an option with one expiration date with the simultaneous sale of a similar option with a different expiration date.

There are endless variations but the most common approach is buy or go long the time spread which involves selling a near term option and purchasing a later dated option. At its most basic a calendar spread will use the same strikes, sometimes called a horizontal spread, in which the main benefit it benefits from time decay as the near term option sold short decays at a faster rate than the longer dated option purchased.

In fact, for a straight calendar spread using at-the-money strikes the delta is neutral, meaning the optimal scenario is for the price of the underlying shares to stay flat and remain at the strike price with the near term option expiring worthless.

You can give calendar spreads a directional bias using out-of-the-money strikes. In this case, even as both strikes are still the same the optimal outcome is for shares to move towards the strike price. A bullish calendar spread would use OTM calls. A bearish calendar spread would use puts.

The directional bias or delta of a calendar spread can be ratcheted higher by employing a diagonal calendar spread. This involves using different strike prices; buying a longer dated option with a strike price that is closer-to-the-money and selling a further out-of-the-money. Even though this will come with a higher cost or greater debit it still provides a positive theta.

The other feature of a long calendar spread is that it is typically long vega which means it will benefit from an increase in implied volatility.

We can take all this information and see that right now, thanks to the recent market decline unique opportunity for establishing low cost calendar spreads for downside exposure heading into the crucial, and often cruel, October earnings report season.

The first item to be aware of is that the sharp decline during August not only sent volatility levels, as measured by the VIX, spiking sharply high, it also caused the term structure of the both the VIX futures and the underlying S&P 500 Index options into backwardation. That is, the near term options have a higher implied volatility than late dated options.

A “normal” structure is one of cantango in which later dated options have a higher implied volatility. The reasoning is simple; the longer the time period the greater the probability for a large price move. For obvious reasons you often see a short-lived period of backwardation in individual stocks prior to earnings report.

As you can see below recent market decline, and the upcoming Fed meeting which can be viewed as “macro earnings report” has caused backwardation in which not only are front month options more expensive than later dated but are actually even higher than the “cash” or realized VIX level which stands at 22.95 as of last Friday.

VIX term structure 9.14.15

Given that volatility is mean reverting we can use this to our advantage in creating low cost directional calendar spreads by selling a near term put which has a high volatility and buying a later dated put which currently has a lower implied volatility.

This position will benefit in several ways. Firstly, it has the positive theta (time decay) associated with calendar spreads. Secondly, volatility levels will either begin to decline, which will mean a sharper drop in the front month than the later date it reverts to a normal contango. Or, if volatility levels increase it will due to resumed sell-off in the stock market meaning our bearish diagonal calendar spread is moving into-the-money and profiting from the directional move.

Let’s look at two specific examples in the SPY. I’m targeting selling September Week4 puts, which expire 9/28 and buying October puts which expire on 10/16.   The September options currently have an implied volatility of 29% while the October options’ implied volatility is at around the 23% level. In both cases we are selling high implied volatility and buying low implied volatility.

What I especially like about this is that once the Fed meeting passes this week investors’ attention, and nervousness will focus on the upcoming earnings season. And that should start to inflate the premiums of the October puts we own. If the put sold short expire worthless we will now have a very low cost basis for October options which provide unlimited downside potential.

Let’s look at two specific examples:

The first uses the same strikes out-of-the-money.

-Sell the Sep. Wk4 $190 put

-Buy Oct. $190 put

For a $1.55 net debit.

This position as negative delta of -0.27, meaning it starts at the equivalent of being short 27 shares. It also has a positive theta of +0.18 meaning you collect $18 a day in decay.

This is what the risk graph looks like:

Calendar risk SPY 9.14.15

As you can see the peak profit comes at $190 at the September expiration.

The second is a diagonal spread in which we sell a further out-of the-money September put and buy a closer to the money October put. Specifically;

-Sell SepWk4 $186 put

-Buy October $188 puts

For a $1.70 net debit

This position starts with a slightly higher delta of -0.32 but the the same positive theta of +0.18.

This is what the risk graph looks like:

Calendar diagonal SPY risk 9.14.15

As you can see it has a slightly lower probability of achieving a profit but a higher risk/reward ratio.

The time is right for calendar spreads. Play around with a variety of strikes and set up the one that best aligns with your thesis and risk tolerance.

— Steve Smith

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About the Author: Steve Smith