Calendar spread value relative to IV

S

Sakti

Many options guides out there suggest that buying calendar spread will profit when IV increases. This is often not the case?
From what I can see, front month options IV tends to make larger moves than back month options'.
e.g. buying Jul/Aug or Jul/Oct WBA calendar spreads at 9-June as per attached graph will not result in any profit from the IV rising.
Or am I completely missing something here?

Thanks
 

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The expected behavior of the term structure is that IV moves proportional to square root of time. So if you structure rtVega neutral calendar, (e.g. equal notional ATM options) you will, in theory, be hedged against normal IV moves. Your primary exposures are gamma and non-RT moves in the term structure and this assumes that you have a good way of extracting alpha out of these two risks.
 
Thanks for the explanation. So the IV moves around earnings are considered non-RT moves?
Trying to think of a possible strategy that will benefit from the IV drop, eliminate/minimise gamma exposure, at the cost of theta.
Initially considered reverse calendar spread. But in my 'tests' thus far, the front month IV crush will cancel out or exceed that of the back month... buying calendar spreads through earnings are even more profitable, while reducing your gamma exposure.
Anyway, trying to see if there are certain conditions that will allow this type of play.
 
Root-time sensetivity follows from the expected change in ambient volatility, which is obviously not true if you are expecting a single day event. Instead, think on how to combine ambient vol and event vol into a single vol number for a given maturity which would give you fair vol (*). The only way you can play "vol crush" on a calendar spread is if you think that one of the legs is mispriced relative to the other when factoring in the possible earnings move. So gamma is a required part of your risk unless you start doing fancyer stuff like buying atm and selling wings (**). My general experience is that, unless you are a market maker that collects vig on every transaction, you want to keep the earnings play simple (i.e. single expiry, single strike).

* in short, if you have ambient vol and expected event move you can calculate fair vol for any maturity (excluding term premium etc) and if you have implied vol for two maturities, you can calculate the ambient vol and expected event move.
** while you can construct positions that appear to have good decay and convexity profiles, you are opening yourself to other risks, so your mileage may vary
 
SLE, why should anyone trade options or use options to express an opinion with regard to price movement or lack of movement or otherwise ?
 
trilogic said:
SLE, why should anyone trade options or use options to express an opinion with regard to price movement or lack of movement or otherwise ?
More...
Are you asking how specifically one would look at an earnings/event play or are you asking an philosophical question "why should one ever trade volatility using options?"
 
sle said:
Root-time sensetivity follows from the expected change in ambient volatility, which is obviously not true if you are expecting a single day event. Instead, think on how to combine ambient vol and event vol into a single vol number for a given maturity which would give you fair vol (*). The only way you can play "vol crush" on a calendar spread is if you think that one of the legs is mispriced relative to the other when factoring in the possible earnings move. So gamma is a required part of your risk unless you start doing fancyer stuff like buying atm and selling wings (**). My general experience is that, unless you are a market maker that collects vig on every transaction, you want to keep the earnings play simple (i.e. single expiry, single strike).

* in short, if you have ambient vol and expected event move you can calculate fair vol for any maturity (excluding term premium etc) and if you have implied vol for two maturities, you can calculate the ambient vol and expected event move.
** while you can construct positions that appear to have good decay and convexity profiles, you are opening yourself to other risks, so your mileage may vary
More...

What I do is use the back months to predict IVol after the event for each month and strike. Then model those values and see what my break even points are for that date. If I'm comfortable with my expectations, I'll do that trade. This has worked very well for me for many year, except I should sell calendars more often, and I rarely do that. The hardest part is waiting. I often enter the trade too early. It's hard to wait until the last hour of the day.

You need to have some expectation of where the stock might go or not go.
 
1245 said:
What I do is use the back months to predict IVol after the event for each month and strike. Then model those values and see what my break even points are for that date. If I'm comfortable with my expectations, I'll do that trade. This has worked very well for me for many year, except I should sell calendars more often, and I rarely do that. The hardest part is waiting. I often enter the trade too early. It's hard to wait until the last hour of the day.

You need to have some expectation of where the stock might go or not go.
More...

Just to clarify, are you shorting credit spreads on the front month option after earnings, with strike being the break even points?
Regarding waiting till the last hour, I often see that highest IV occurs not long after the earning date confirmation, not at the last moment prior to the actual earning announcement. Do let me know if I'm way off.
Agree with Sle in regards to keeping earnings play simple. But I believe selling calendars have potential given certain conditions. These conditions I do not have good grasp of yet, due to lack of knowledge and experience :( Still trying to explore.
Will need to check out ' buying atm and selling wings' as per Sle's suggestion.
 
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