ATM Calendar Spreads, Are You Aware Of The Hidden Gotchas?
Over the years of being both an options trader and trainer, I have seen different option strategies that come into and out of vogue. It seems almost cyclical, like fashion.
For me, every option strategy has its time and place to be traded. I look at each option strategy as a tool for an application. Rather than trying to apply a single tool to every situation, I prefer to assess the situation and pick the right tool.
There seems to be a lot of emphasis right now on at-the-money (ATM) Calendar Spreads. I thought it would be worthwhile to steal some insights from our Trading Trainer Academy program and bring attention to some hidden gotchas that, if not accounted for, could turn a highly profitable ATM Calendar Spread into a big loser.
What are ATM Calendar Spreads? ATM Calendar Spreads are sometimes called ATM Time or ATM Horizontal Spreads. They can be constructed with either put or call options. They are constructed by buying an at-the-money option with an exercise or expiration date farther out-in-time. Then, selling an at-the-money option (with the same exercise or strike price as the option bought) with an exercise or expiration date closer-in-time. The idea is to profit on an underlying stock that is channeling horizontally by capitalizing on the difference between the rates of option time decay.
The ATM Calendar Spread profits based on the difference between the rates of time decay of the option bought that expires far out in time versus the option sold that expires closer in time. ATM Calendar Spreads profit, at first glance, so long as an underlying stock stays within a certain range.
The gotcha associated with ATM Calendar Spreads is that an investor might not factor in the affects of implied volatility changes (option traders call this the "Vega Risk"). I've looked over the shoulder of some ATM Calendar Spread traders, and have been surprised, if not alarmed, that they'll factor in the underlying stock price range and the difference in time between the two options and leave it at that.
The higher the volatility is, the higher the option price will be. Implied volatility is a factor in an option's price. Higher implied volatility develops because the market expects a big move on the underlying stock price either up or down. Let me emphasize that volatility does not predict direction or even specify that a directional move will happen, it is just the expectation of how far a potential move could take that stock price.
It turns out that even though our primary focus for profiting from an ATM Calendar Spread is the difference in option time decays, the strategy is actually much more sensitive to changes in volatility. An increase in implied volatility will cause a "volatility rush" in the ATM Calendar Spread, causing the amount of profit to grow and the range the underlying stock must stay within to profit, to be larger. These are both good things.
With the assessment of implied volatility and implied volatility skew, an ATM Calendar Spread trader can set themselves up for not only profiting, but also potentially realizing a "volatility rush" that will only add probability of an increase to their winning.These ramifications are not good at all and can actually take a potential winning trade and make it a loser.
Investors look for underlying stocks to trade ATM Calendar Spreads on that they expect to trade in a narrow range for the next 30 to 45 days. The gotcha is if they stop there. It's imperative that they also evaluate implied volatility.
Because implied volatility has a tendency to revert back to its mean, I advise to look for implied volatility to be in the lower 25% of its yearly range. I also recommend comparing the implied volatility of the two options being considered for the ATM Calendar Spread. If anything, you want the option you sell that is closer-in-time to have a higher implied volatility than the option you buy that is farther out-in-time. This is called having a positive implied volatility skew.
In conclusion, ATM calendar spreads are trades that have a high profit probability and a favorable reward-to-risk. However, if the trader does not factor in changes in implied volatility when considering the trade, a calendar spread that seems a dream at the time the trade is being considered, may turn into a nightmare as the trade progresses along.
Be sure to analyze the implied volatility while you are doing ATM Calendar Spreads. Specifically, trade calendar spreads with low historical volatility at the time the trade is being considered and look for positive implied volatility skew.
Article Source: FxTradingStock.com
About the Author
A.J. Brown is widely recognized as "The World's Most Disciplined Option Trader." He has been actively trading options for more than 10 years, and has published daily insights for his Trading Trainer members every single night, 5 days a week, since 2002. A.J. currently resides in Fort Collins, Colorado. Learn A.J.'s and sign up for a complimentary Option Trading Lesson at Trading Trainer.
by: AJ Brown
Total views: 43
Word Count: 795
Date: Sat, 19 Mar 2011
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