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Calendar Options Strategy Video Series 1 of 7

In this calendar options spread class we explain how the Calendar can behave as a negative Vega trade. This is very important to understand. Many option traders do not understand volatility well enough and believe this type of trade always makes money when vols rise and it always loses when IV drops. However, this is far from the truth. The calendar spread can be used to make money when IV drops just as effectively as when it rises.

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Calendar Options Strategy Video Series 1 of 7

Video Transcript

Well, hi there everybody! This is Morris from San Jose Options and we’re diving into the San Jose Options archives. This class was originally presented way back in 2009. But I was looking it over and there’s still a lot of great information in this presentation. Here’s your remake.

This was a discussion about Calendar Spreads and the first thing that we need to know is a traditional Calendar Spread is created by selling and buying the same strike but at different months. You sell the near month and you buy the back month. So here’s an example right here of the SPX. We’re looking at a situation where you would sell the front month. Let’s say the 1,000 strike, and then you notice how the back month over here, October, November, then you’re looking at purchasing the same number of contracts at the same strike. So again you see both of these positions one short is at the 1,000 strike and the long is also at the 1,000. The difference here is your month and again notice that your selling the front month and buying the month that’s farther out in time.
Now there’s lots of ways to do this. You can do them short term. Some people like to do weeklies. If you do a weekly trade, though, just be aware that you’re going to create a very tiny risk raft, a very tiny calendar to be very narrow. When you go farther out in time, let’s say you sell the first month at 50 days, then, you’ll end up with a much larger, wider calendar. So you can build those in your software and see the difference and observe and find something that you’re comfortable with.

The other thing to note is the volatility skew. This is extremely important in this trade. Again, you could set them out different ways. You can always sell, let’s say month 1 and as I just described could be out 30 days, it could be out 40,50, 60 days. We even have some contracts that go out 2 years now. And then you can buy month number 2 or you could actually buy number 3, buy number 4. You can actually put more time between them. But the important thing here is the volatility skew that you’re capturing.

I referred to this volatility skew as a wave. Imagine as you go through time, you have this wave, let’s draw. I like to think of the option chain as a triangle. So shorter term your option changes just really tiny. Let’s say this is the whole thing that goes from in the middle around your 50 delta down to the 1 or down to the 0 and then your 1 over here so this would be or let’s say 100. Say your option changes just very tiny then farther out in time, when you travel the same deltas, like 1 to a hundred over here, with your 50 in the middle, your option chain is much wider. And it’s similar with these trades that you build.

Now what I mean by the wave is as things progress in the market, as there’s market news that comes out – global issues and things or maybe a market crash, things like that that happen – you get this wave that comes out and goes through time this way but you also get a wave that goes out like this way. So when I think about volatility and about contracts and things, I think about the waves going the different directions. Depending on how the wave just happens to hit your strikes, you’re going to create a volatility skew. And a skew could be either negative or positive and it’s going to be changing all the time but the goal is to enter the trade when you have the best possible skew. For example, let’s say let’s draw this wave here and say it’s waving like that. And then over here it’s little bit smaller and for some reason this point just gets spiked up, the volatility on it is spiked up. So it’s kind of like the top of the weight. And then let’s say down here, let’s say at this point, notice like this point here for example. Let’s say this one’s at the bottom of the wave, so the IV’s low on this one. So this is what I, in my terminology the wave I teach and talk about volatility, talk about the wave. So the wave in this situation is just hitting you just right. You have your skew up here, this one’s a higher volatility, this strike over here, let’s say is a lower volatility. And so now you’re taking advantage of the volatility wave, it’s just falling across your contracts for whatever reason the best that it can be.

So, when you have this type of wave in your favor, that’s the time to start your Calendar Spread because you’re selling this front month, remember, over her. You’re selling this one and you’re buying this one, so we want to sell this one. You want to sell it high and you want to buy it low and that’s really how business works.

So that’s all for this tutorial, this is the first part of a few different slides on the Calendar Spread. Thank you very much! This is Morris. Go visit San Jose Options, sjoptions dot com (sjoptions.com) or sanjoseoptions dot com (sanjoseoptions.com). Thank you very much!