Papale on Calendar Spreads

It’s hot.  It may be hot where you are too.  In Chicago it’s not a dry heat but more of a wet heat.  Muggy.  Feel like I need a shower after walking 5 blocks to the train.  But I’m not complaining.  Six months from now in January I’ll look back on these days with almost  a fondness as we drop below 0.  So enjoy the summer.  And grab a shower if you need to.

A common strategy year in and out is the calendar.   But like all trades they have risks.  The long calendar is technically a long vega trade since the long farther out options have larger vega than the short front month options.  Overall vega is just the difference between the two monthly vegas.   So if volatilities are falling, the calendar will lose money.  Makes sense right?  However, in reality the calendar does not always behave like a long vega trade.  Here’s why.  The vega risk on the calendar is based on the implied volatilities for both months moving the same amount.  In reality that does not happen all the time.

For example, during extreme market selloffs the front month implied volatilities rise much faster than the further back months.  This is expected as traders and money managers reach for the most downside protection and that is generally the front month options.  In this case we could lose the same or more on the smaller front month vega than we make on the larger back month vega position.  So even though volatilities went up and we were long vega, we could break even or lose from the vega.  So when evaluating vega risk on multi leg trades, watch how the volatility moves for the particular strikes.  It might be a bit different for each.

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