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Calendar Options Strategy Video Series 5 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 5 of 7

Video Transcript

Hi everybody! This is Morris from San Jose Options. In this class, we’re going to talk about calendars a little bit more but we’re going to look at some of the math behind the topic and why you make or lose money with this spread. And then hopefully you’ll understand why I really stress this volatility skew and how it works and how it’s so important that you get it in your favor when you begin to trade.

Let’s talk about overall volatility if we’re looking SPX or Russell or something like that. A little vol may be about 20, it gives you some premium but maybe it’s not so volatile that the underlying is moving around an awful lot. Somewhere, maybe this type of range might be appropriate. So your underlying is somewhat stable is what that means but at the same time, there’s enough volatility ‘til we actually get in some premium.

Next, let’s look at the numbers here. Let’s say that you have, and these numbers may not of course respond to what you’re trading. But let’s just talk about, let’s say you have some negative Vega, maybe 7 points. It’d be a tiny, tiny, trade but just keep an amount simple. Let’s say you have -7 Vega in the front month because you sold some contracts. So your short contracts have a negative Vega, your long contracts have a positive Vega. Let’s say in the back month you have a 15, a positive 15 Vega. If you look at the beginning of this trade, you add them up and you have an 8 Vega to start with. This is kind of your position. You would think “While a volatility rises, I’m going to make money because I have a positive Vega trade.” But we’ve already discussed that that’s not true. Sometimes it will be, sometimes it won’t. it depend if the market has a reaction like the income style or if you have a debacle. That’s really where it comes down to.

In this example, we’re going to look at if there’s a drop in volatility of 5% there and a drop over here at 3%. If this is your Vega position, then, when you just do the basic math, you have the 7 times the 5 and you’re looking at a $35 profit. You have 7 points of Vega so theoretically, following like the black shawls in similar pricing models, then this means that for every 1% of your volatility increase, you would lose $7 and the opposite is true for every 1% drop in volatility, then since your Vega is negative, your making $7. Here, if the vols drop 5%, you’re looking at a $35 profit.

Now, when you look at the back month, again, because they don’t follow each other exactly; it depends how far on time it is, how close they are together. What if you’re doing weeklies, and they’re only a week apart so they’re just kind of moving hand in hand. But what if you have a month between the contracts or two months? Then it’s going to be a different reaction.

In this episode, let’s say you had a 3% drop, you have 15 points of Vega. Again it’s positive Vega, so as the balls drop it loses money, so this one loses $45. Overall, when you have all this coming into your trade, let’s just say it loses about $10. So that’s kind of how the numbers work together and that’s why it’s important to try to get the skew in your favor at the beginning of the trade because if it doesn’t, after you enter the trade, if it doesn’t turn in your favor, then, you can end up losing on that. try to get the skew the best you can when you start that particular trade and in that way over time, hopefully, you’ll get a volatility change that makes sense for your trade. Then, you don’t have the $10 loss, instead you might have a $10 win.