What is the point of doing a Calendar Spread?

[water7]

The big question is - Is this better than doing V-Spreads? I think that's the main reason a lot of people don't know about this. The Calendar seems overly complex and it doesn't offer a better risk/reward profile than a V-spread.

Although in my gut, I am certain this is a more conservative strategy.

what do you mean by V-spread? is that long straddle/ reverse butterfly?
are we talking about weekly / monthly calendar?

thanks

 

[ironchef]

The horizontal takes advantage of how the vol curve could evolve. Not a big source of risk/return, but a keen optimization of the desired exposure. You might also be able to make a new spread with a nice positioning after the front month goes into expiration...morphing the exposure.

Some days, I question all the trouble that I make for myself.

Reminded me of what Terry'sTips said.

Far month options usually have higher IV.

 

[Stymie]

You make money off the decay on the front month but wouldn't the back month where you are long decay also?

Example:

You sell front month for $1.
You buy back month for $2.

Front month expires worthless, back month is now worth $1.

In my head your net profit is $0. But I don't think this is the case... I assume the back month would decay less than the front month due the options having exponential decay on expiration. But is it really that much more? A few cents maybe? What's the risk?

You are right in the Theta decay of the front month is higher. But Theta and Vega are inversely related. Thus if vols are expected to go up, the front month will go up less than the back month. That's the risk. If vols drop significantly, you will lose more on the back month.

The challenge is the cost of trading the spread as it's too high.

The other way of thinking about the calendar spread (same strike)is a poor mans covered call.
Instead of buying the stock and selling a call. The idea is to buy a deep ITM long dated call and Sell a short dated OTM call. This strategy allows you to limit your loss and reduce the amount of capital required improving your roc. This introduces a directional assumption in the strategy by using different strikes. This works well when longer dated vols are lower than normal. The risk is the same which is the premium paid and it all gets unwound together.

Risks:
Theta / Vega relationship
Strike /Delta direction over time relationship

 

[sle]

Thus if vols are expected to go up, the front month will go up less than the back month.

That is not true most of the time.

 

[Stymie]

agree - not easy to find a flat vol skew or equal shift up across maturities but when it does happen, I know why I'm making money. When it is flat or upward sloping vols all the way out - I have no problem selling one year options. The premium is huge relative.

 

[water7]

its not about skew, stymie
just a simple net vega effect from 2 different terms' change

 

[Windlesham1]

just limit profit to 25%,and move on

 

[ironchef]

agree - not easy to find a flat vol skew or equal shift up across maturities but when it does happen, I know why I'm making money. When it is flat or upward sloping vols all the way out - I have no problem selling one year options. The premium is huge relative.

Do you sell ITM, ATM or OTM under the circumstance? Naked?

 

[RGLD]

agree - not easy to find a flat vol skew or equal shift up across maturities but when it does happen, I know why I'm making money. When it is flat or upward sloping vols all the way out - I have no problem selling one year options. The premium is huge relative.

Is there a graph where you can see the skews?

 

[Stymie]

Do you sell ITM, ATM or OTM under the circumstance? Naked?

There is no silver bullet for picking your strikes - you have to understand how time and vols impact pricing to balance profit vs time exposed to tail events. Standard deviation is the square root of variance and therefore it is proportional to the square root of time. When the vol skew is flat, the real premium further out tends to be overstated relative and thus it's worth selling out even one year. This is much easier when vols are extremely high and a flat skew - the premiums are so high you don't need a calculator - the break even puts you at prices never seen before or ATM Straddles can put your breakeven below $0.

Since we are not market makers, its not about shaving a nickel off a fair price, we need to find big aberrations and when you do find them, it's best to go out far and lock those in - when they are expensive - sell premium but there are also times when they are too cheap and you can make more money buying one year premium. When vols are big, it's hard to do spreads as you give up much of the premium on your long option so I tend to do naked options when the premiums give a big cushion. If I'm scared of a big move, then buy stock and do a ratio.