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Why Calendar Spreads Are An Oxymoron

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I understand the attraction with calendar spreads, I really do. What’s not to like about a long volatility income trade? Their risk profile looks fantastic, especially if the stock closes right at your strike price at expiry. However, what are the chances of that actually happening?

What I don’t like about calendar spreads is that you want the stock to stay within a specified range, yet they are long Vega. Isn’t that an oxymoron?

How can the volatility of a stock increase while it remains range bound?

Sure, you can use calendar spreads that are out-of-the-money and therefore incorporate a directional trade. This is something I do occasionally as outlined here. But I don’t really trade plain vanilla at-the-money calendars.

The other problem with calendar spreads is that you are trading two different expiry months, and are therefore exposed to volatility skew.

As with anything stock market related, you want to buy low and sell high. The same goes for implied volatility. When trading calendar spreads, you want to make sure that the implied volatility of the option you are buying is not too expensive relative to the option you are selling. A good rule of thumb is that the back month IV should not be more than about 1% higher than the front month.

Option payoff graphs also can give unrealistic expectations for the unwary trader. For ease of calculation, all payoff graphs assume that the implied volatility of the 2 options converge at expiry of the front month. That’s not always the case. What happens if volatility in the back month unexpectedly drops as the front month expiry draws near? You’re left with a much lower return than anticipated, that’s what. Check out these calendar spread payoff graphs. Look what happens if we have a 2% drop in volatility?

SPY Calendar Spread

SPY Calendar Spread

SPY Calendar Spread with vol drop

SPY Calendar Spread With 2% Vol Drop

As you can see, you maximum potential profit drops from $393 to $183. That’s a pretty big drop, and that’s just from a 2% drop in volatility.

I prefer to incorporate calendars into an overall portfolio or trade as part of a combination, with iron condors as an example. Using calendar spreads this way, helps alter the Vega structure of your trade in a more favorable way.I know people use calendars quite successfully, however I find it hard to see the attraction of using at-the-money calendars as a stand alone strategy.

5 Comments
  1. ATM calendar spreads are attractive when you have a view about changes in IV term structure. IV doesn’t change uniformly across expiration cycles; being exposed to IV across cycles is not only not a “problem,” it’s the whole point of the trade.

    1. Good point Jared, thanks for your comment. In what scenarios do you like to trade ATM calendars? Earnings plays?

      1. I don’t trade them on earnings since it’s so hard to make any reliable predictions around earnings. Otherwise, any time IV relationships deviate from the long-term normalized range.

  2. WGF_Flame says:

    its like betting on implied volatility change / Real volatility change

    if implied volatility change out-wight the real volatility change then you will win.
    you can say its a defensive approach, betting on 2 assets that have negative correlation between them. (like in pair trading)

  3. Hari Swaminathan says:

    Gav, I think the problem has to do with platform software deficiencies – I’ve never seen a Calendar expire exactly as it should even if you get your price point. And maybe you’re right about that convergence issue of IV going to the front series. I always never hold a Time spread to expiry as it always disappoints. I’ve tried tweaking the IV changes in both front and back series (separately) and even that does not produce good results. I do like Double Diagonals though especially if you can stage it in at appropriate times, but don’t hold until expiry. You’ll come up short

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