What’s on Your Calendar [Spread]

Dmitry Pargamanik and Will McBride, the cofounders of Market Chameleon, join IBKR’s Jeff Praissman to discuss option CalendarSpreads.

Corresponding Webinar: https://www.interactivebrokers.com/campus/webinars/navigating-scanning-for-and-all-things-calendar-spreads/

Summary – IBKR Podcasts Ep. 190

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hey everyone, my name is Jeff Praissman with Interactive Brokers, and it’s my pleasure to welcome back to our IBKR podcast studio from Market Chameleon, Will McBride and Dmitry Pargamanik. Hey guys, how are you?

Dmitry Pargamanik

Good. Thanks for having us, Jeff.

Will McBride

Thanks for having us, Jeff, as always.

Jeff Praissman

Oh, my pleasure, and we just finished up another one of our great monthly webinars. This time it’s on calendar spreads, and it’s always great to have you guys swing by the studio after the webinar. To kick it off for our listeners what defines a calendar spread?

Dmitry Pargamanik

When we talk about a calendar spread with options, it involves two options. You’re buying an option and selling an option. And the most popular option people probably know involving spreads is a vertical spread, where you’re buying and selling an option within the same expiration. A calendar spread has to do with time.

You’re using the same strike, but you’re, but you have one option that you’re buying and selling in one expiration and then another in a different expiration. And it really involves a time and a term structure where you’re looking at for different reasons why you would want to spread out buying one expiration versus selling another.

Jeff Praissman

Is a calendar spread the same as a diagonal, or is a diagonal a calendar spread, or are there

Dmitry Pargamanik

Yeah,

Jeff Praissman

Or is it one is one, but one’s not the other?

Dmitry Pargamanik

Yeah. So the diagonal spread is interesting. It’s a similar concept where you do have two options on different expirations but in a diagonal spread, you’re also using different strikes. And there are, certain reasons you might want to do that. If you have a more directional type of bias, you might want to use a diagonal spread.

Also, when we look at options, an at the money option in one expiration is a different strike for an at the money option in another expiration because of the cost of carry. So sometimes when you see a diagonal spread, it’s really still aiming to spread off the options using the at the money strikes, but because of the cost of carry, those strikes will differ the expiration it’s in.

Jeff Praissman

Got it. So essentially you’re long one strike in one expiration, you’re short another strike in another expiration. Yeah true calendar spread, it’s the same strike.

However, a diagonal is a type of calendar spread in which it’s just two different expirations and two, different strikes.

Although, as you just pointed out, in reality, those two different strikes may be closer to the money than having the same strike in both expirations.

Dmitry Pargamanik

To account for that cost of carry component. And I think people also use those diagonal spreads as an alternative to a buy write. So if you’re looking to sell an option to collect premium instead of going out there and buying the stock, another alternative is to find a different option As a hedge against that. That one strike that you’re selling.

Jeff Praissman

Got it. And you beat me to the punch there because, as always, our listeners want to know what are the uses? And they’re always generally more than one use for any kind of option strategy, for the strategy. Besides for that, what are some other ways that traders will use a calendar spread as far as part of their overall

Dmitry Pargamanik

Right. Some of it has to deal with your outlook, especially along the term structures. If you’re looking maybe to get long Vega, you would want to buy the option that’s longer dated. If you want to hedge some of that risk off, you may try to sell an option that’s shorter dated, and that will get you a long Vega position.

Also, if you think that the implied volatilities between the two expirations has diverged to a point where you think one expiration is a relative basis cheaper than the other expiration, you might want to spread that off with the outlook that term structure will revert to more normal level that agrees with your outlook.

Sometimes people will just want to say own an option on a specific expiration could be due because they want an option that covers a certain event, like earnings. And, if you Like the implied volatility at this moment, and if your intent is to hold it for that earnings event, sometimes you could finance some of it by selling an option that’s shorter dated that doesn’t cover the event that will expire prior to that with the goal or aim of having that first option expire worthless and keeping that other option that may cover that event.

Jeff Praissman

And I guess also too, it’s important to note that not necessarily an opening trade on both legs, right? So another use would be, even though it would come up on the print as a calendar spread, the trader might just be closing one leg and rolling it to another, and just using that spread as well to to

Dmitry Pargamanik

Yeah, that’s correct. And we do see a lot of volume in calendar spreads that involves rolling a position. So if you have, let’s say a long position in an option that’s about to expire the same day or next day, and you want to hold on to that risk exposure by rolling out that option to a further out expiration you could just enter in a calendar spread because a calendar spread will simultaneously allow you to buy that next option going out while you’re closing out of the option that you’re long in closer expiration.

So even though it might look like a calendar spread when it gets printed on the tape, actually someone could be just rolling out of a position going out to a further month.

Jeff Praissman

Now, is a calendar spread a bearish strategy? A bullish strategy? Either, neither?

Dmitry Pargamanik

Yeah, it’s how you set up the strategy. Besides the two different expirations you’re choosing, you have to pick a strike. And in a calendar spread, you’re looking at the same you’re looking at two different expirations, but same strike. If you’re long, the calendar spread the longer term short the short, shorter term option, your sweet spot on that first expiration is that the stock closes at the strike.

Cause if it closes at the strike what happens is then that first option ideally is worthless, right? And all the premium goes away. It stops right at the strike.And then what you are left with is the longer dated option. When the stock is right at the strike, that’s where the at the money premium is the highest.

So your longer dated option will be all time premium, right? It’s right at the strike. The shorter dated option goes away. So by picking those strikes relative to the spot price, you can create a directional bias.

For example, the stock’s a hundred, if you, let’s say put spread on the 80 strike you want the stock to float right to 80.

If you pick a strike, which would be a bearish bias, if you pick a strike, that’s 120 and the stock’s at a hundred, you want it to float up to the 120 and the stock to sit at that price at the first expiration. So that would be a bullish bias.

And of course, if you just pick the strikes where the stock is right at that moment, then you don’t want it to move from that strike. So there is a way to structure it that also includes a directional bias. And that will depend on which strikes you choose.

Jeff Praissman

And, just to think about other spreads like obviously looking at count and spread, you’re dealing with multiple variables, right? The two different expirations throws another kind of level into it, where looking at a vertical spread I don’t want to say it’s easy to value it, but you’re looking at two things in the same expiration.

Obviously, if it’s a call, the higher strike has less premium than the lower strike and vice versa. If it’s a put, what goes into valuing a calendar spread, since you are dealing with expirations? They got different events going into it, such as earnings, such as a dividend, such as some sort of news release, or if it’s like a drug stock, some sort of FDA potential approval and so forth?

Dmitry Pargamanik

Yeah. So there are a lot of factors that go in there and make it a little bit more complicated because you’re dealing with options on different expirations.

And the important thing to also keep in mind is that once that first option expires, it’s no longer a calendar spread because that option will either expire worthless and then you’re left with that remaining option that still has time to maturity, or it could be in the money, which will then convert to stock.

And if you do nothing, then you will have a stock position and an option position, but it’s no longer a calendar spread. So the calendar spread does need to be managed from that perspective.

It doesn’t remain a calendar spread all the way to the second expiration. There are different factors that go into it. And one of them, like you mentioned, is our events. When you look at a typical term structure, let’s say an SPY, Nothing unusual or expected heightened volatility, then the term structure looks like it’s sloping up as you go out further in time.

And the idea behind it is as you go out further in time, there’s more uncertainty. If there’s more uncertainty, then the option premiums will be higher, right? More chances of something happening. However, there are times where that could get inverted and that’s where you have a lot of uncertainty happening at the moment.

The markets could be volatile, less liquid. And what you’ll see is that the implied volatility in the front month will jump up and it’ll be higher than the month’s going out further. And you really see that when you have earnings. So that’s very typical around earnings, that the front month implied volatility is higher than the longer dated options.

Sometimes you’ll see that even in the market in the indexes and so forth when we have all of a sudden something going on that’s creating more uncertainty.

It could even be like a Fed meeting, right? Where we know that there might be heightened volatility because we don’t know what they may do or say or give an outlook.

So that’s something to watch out for because the implied volatilities will differ. And when you have an event, there’s a pump and that pump is there because of that uncertainty.

So that can make a term structure even look jagged, right? So sometimes you’ll have a pump in a specific expiration along the term structure.

So those events make a difference in the expectations of volatility. The uncertainty make a difference in that term structure.

Jeff Praissman

So volatility is really the biggest contributor as far as how those two expressions could differ. And pivoting a little bit to risks, right? So obviously we just talked about events and, so let’s just say earnings is supposed to be released in July, and you have the June- July calendar spread on, all of a sudden they get moved to June, all of a sudden that spread has a whole different value, right? So that seems like that’s definitely a risk. Something like that, an event, change of date, or a sudden event comes up. What are some of the other risks, though? Even if they’re off-setting positions. Let’s just say I’m short 50 July, 25 calls, and I’m long 50 August 25 calls.

So same strike, I’m thinking like there isn’t any risk, but of course there’s always risk, right? So what are some of the risks associated with, say, that type of position?

Dmitry Pargamanik

Yeah there, there are different types of risk. One is an early exercise. So you have potential to have One of your options that are in one expression be candidate for an early exercise. And what can happen is, maybe let’s say there was a dividend or if you’re a put spread, the interest rate, what can happen is that you could get assigned on your short option.

And then if that happens, your calendar spread gets converted to an option and a stop, which is then like a synthetic, depending on if you have calls or puts or what side. So that is a risk that you need to be able to manage and anticipate because you can anticipate options if they become even an early exercise candidate.

Based on like dividends and not always, but there are things you can do to anticipate something like that and manage that risk.

There’s risk of certain events that could collapse a time spread too. Like for example, if you have a calendar spread where you own a lot of premium in the longer dated option and you’re short premium in the shorter option, but on net you have a big debit.

If a stock, let’s say, gets taken over for cash, what will happen is the stock moves to a new price, and it’ll sit there. That’s it. It’s not going to move its regular volatility and that’s over.

So that could collapse a time spread potentially from the longer dated options, just all the premium options.

All the time premium, the volatility premium will get sucked out and as the further you go out, obviously the more premium risk you have.

And then there’s a Vega risk of course, because when we look at options that are for longer dated, even if you run the same implied volatility, let’s say you have a flat implied volatility, from shorter data to longer data, let’s say it’s 20.

Everything is implied volatility is 20. A one implied volatility move in a shorter dated option is not the same thing as a one implied volatility move in a longer dated options when you think about it in terms of actual dollars, right? So the longer dated options are much more sensitive to an implied volatility move. So, the dollar value change in an option, let’s say a year from now, could be ten times greater for one implied volatility move than one that’s just expiring tomorrow. So there’s a Vega risk in the strategy that you have to be aware of, especially when you’re trying to even trade one implied volatility versus the other one, there is a Vega risk involved there that you have to account for. Because obviously the longer ones are more sensitive to Vega.

Jeff Praissman

Now, are they always one to one contracts or do people use ratios as well when doing calendar spreads?

Dmitry Pargamanik

Yeah. We’ve seen people use ratio calendar spreads. A typical calendar spread, of course, it’s always the same ratio. One to one, but people use them just like ratio vertical spreads. We’ll do ratio calendar spreads, and you may want to own two options and only sell one option against that in a different expiration and vice versa, or three to one or whatever ratio you want.

Sometimes people use ratios just to get a dollar neutral because, you have a longer dated options, it’s more expensive, shorter dated option, less expensive. We’ll see them doing dollar neutral or whatever reason it is, we do see people using it in ratios as well.

Jeff Praissman

We’ve talked about it really just being two expirations. Can calendar spreads be in multiple expirations, more than two? Could you have a three expiration or four expiration calendar spread? Is that possible?

Dmitry Pargamanik

So we see that a lot just monitoring the trade tape. Could use a time spread with more than two expirations, just like a butterfly. Of course, it’s no longer a typical calendar spread, but you could do a time split spread.

If you have a butterfly, for example, a butterfly would use three strikes within the same expiration.

The below strike has one contract, the middle strike has two, then the upper strike has one contract. We’ve seen that kind of same strategy where you use three different expirations. Even on the same stripe, we’ll have one contract shorter dated to in the middle, one longer dated.

So yeah, it’s not as popular as just the calendar spreads, but people do use more than two expiration, more

Jeff Praissman

More than two explorations. Yeah, I was going to say more. Yep now Dmitry, this was great. First webinar was super informative, and now just to follow up with this podcast was great. Are there any other final thoughts you’d like to leave the listeners with?

Dmitry Pargamanik

Yeah, I think as far as this and calendar spreads and diagonal spreads that we talked about, I think it’s important for you as an options trader, to learn and know about these strategies because you never know when you will need to use it and what type of exposure or aim you will have because there are certain times where whatever outlook you have, a calendar spread may be the appropriate strategy, you know?

So learning about the different strategies, knowing their risks and rewards, where they stand to potentially perform the best when you want to avoid them? It’s very important Than just looking at one type of strategy all the time

Jeff Praissman

Another great podcast. And for our listeners, I want to remind everyone that they can find all of our podcasts with Market Chameleon, on our website. Just go to Education, click on Podcasts. You can search through the past ones. You can also go to our contributors. You can go to Webinars and find their Webinars.

And of course on Spotify, Apple music, Google, Amazon Music, all the normal places where you find your podcasts, look for the Interactive Brokers Podcast and more great material from Market Chameleon and Will and Dmitry. Guys, thanks a lot, man. Always appreciate you guys swinging by the podcast studio.

Dmitry Pargamanik

Thank you, Jeff. Thanks, everyone.

Go Source