Taking advantage of time

  • UPST mostly rangebound since May sell-off
  • Nov. options volatility well above Dec. options volatility
  • “Calendar spreads” trade time—but also volatility

In the options world, it can sometimes seem as if all roads lead to volatility—even in terms of the “calendar spread” strategy, which is typically discussed as a way to potentially profit from the way different options lose value over time.

A typical calendar spread combines a short at-the-money (ATM) option with a long ATM option with a later expiration date—e.g., with a stock at $50, a trader could short a November $50 call and buy a December $50 option:

Chart 1: LiveAction scan: Expiration 1 IV > Expiration 2 IV, 10/27/22. IV higher for nearby expiration.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)

Because options lose time value at a faster pace as expiration approaches, the goal of the typical calendar spread trader is to exit the position at or shortly before the nearby option expires, at which point it will have lost most or all of its time value. Meanwhile, the long option that expires later will have some time value left—and, hopefully, will have lost less value overall than the short option, creating a net profit on the spread.

That’s the time element. But the risk-reward profile shows the calendar spread also has a volatility element. Specifically, it needs volatility to remain low or decrease over the life of the trade. Notice the potential profit is greatest if the stock is unchanged—that is, it’s at the options’ strike price—at expiration. But if volatility increases—say, the stock makes a big move, higher or lower—losses can result. In this sense, the calendar spread is a “short volatility” trade, similar to a short straddle or strangle.

Traders shorting volatility prefer to “sell” it when it’s as high as possible—just as they would a stock. That leads us to the LiveAction scan for symbols with the highest implied volatility (IV) in the nearby expiration month relative to the next expiration month:

Chart 2: ATM calendar spread risk–reward profile. Potential profit highest at strike price

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)

Because high IV can inflate options premiums while low IV can deflate them, traders interested in calendar spreads may look for stocks with much higher IV in the nearby month than in a later expiration month. That increases the odds they’d be shorting potentially overpriced options and buying (relatively) underpriced options.

But there’s even more to consider in this type of trade. One of the stocks on yesterday’s LiveAction scan, Upstart (UPST), has traded in an increasingly narrow range since dropping sharply in May:

Chart 3: Upstart (UPST), 5/3/22–10/27/22. Upstart (UPST) price chart. Moving sideways since sell-off

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)

For some perspective, UPST peaked above $400 last October, and was still trading around $160 as recently as early March. Traders who expect the stock to remain in a relatively low-volatility consolidation may see this type of stock as a good candidate for a calendar spread.

It could be. But those traders can’t overlook UPST’s upcoming earnings, currently scheduled for November 8. As discussed in “Sharpening the volatility edge,” IV often increases in the runup to an earnings release—something that would help explain UPST’s November IV being so high relative to December.

Traders can never overestimate earning volatility, as the big down gap that occurred after UPST announced its numbers in May vividly illustrates. That’s the type of volatility surge that can knock a short-volatility strategy, like the calendar spread, out of the box.

A final note on calendar spreads: The position’s risk-reward profile is the same whether the trade uses calls or puts. Since the potential profit is greatest at the options’ strike price, traders who think the stock could move somewhat higher may use options with strike prices above the current stock price, while traders with a bearish bias would do the opposite. Either way, the calendar spread isn’t a strategy designed for situations when a trader expects a significant move, up or down.

Today’s numbers include (all times ET): Personal Income and Outlays (8:30 a.m.), PCE Price Index (8:30 a.m.), Consumer Sentiment (10 a.m.), Pending Home Sales Index (10 a.m.).

Today’s earnings include: AbbVie (ABBV), Aon (AON), Chevron (CVX), Exxon Mobil (XOM), Colgate-Palmolive (CL).


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