Using Time and Volatility for Profits Calendar Trades Using Time and Volatility for Profits

What are Calendars Calendar trades use the difference in time decay and Vega on options with different expirations. Short term options have a very high Theta and low Vega. Longer term options have lower Theta and higher Vega.

Basic Example of a Calendar SPY @ 140.99 Sell a weekly option (7 days to exp.) Sell weekly SPY 141 Call for $1.09 IV of 17.32% Theta -.14 / Vega .06 Protect the position using a monthly (28 days to exp.) IV of 14.93% Buy SPY 141 Call for $2.19 Theta -.04 / Vega .15

Margin Margin is normally calculated based on the debit value of this trade. $2.19 - $1.09 = $1.10 debit

Risk Analyzing risk on this trade is a difficult question max risk = debit amount If you hold all positions until their expiration <- bad idea Normally this is not done Practical Risk is normally less We need to look at the value we will likely get back from the protective option to determine our practical risks

Theta Theta Decay affects both options in this trade It benefits the short weekly option by .14 per day It costs the long protective option by -.04 per day A net of .10 per day advantage This accelerates as we get closer to expiration Considering Theta how valuable will the protective option be when the short option expires? Very important consideration

Vega Vega is most significant in the longer term protective option An increase in IV of +1% changes the value of the protective option by .15 An increase in IV of +1% changes the value of the short position by -.06 1% increase in IV = +8.2% increase in our trade value This advantage increases as we get closer to the first exp date

So how does the trade work? Choose a symbol that isn’t expected to move outside your breakeven range Max profit is at the Strike Price Allow the short option to decay in value Close the position close to the expiration of the short option Close the short option to protect from assignment Close the protective position to regain value

Getting an Edge High IV in the short options mean more potential profits from the time decay Often coupled with high risk of price movement Look for situations where the protective option will have an increase in IV This can be a very strong play when IV is rising

Good Opportunity Stock XYZ is announcing earnings on the 17th We short a weekly option that expires before the 17th The IV of the short option will not be significantly affected by the announcement We protect ourselves with a monthly option that expires just after the 17th The IV of the protective option will be increasing as we approach earnings Increases the profits of the trade & probability of success

Combining Calendars By creating combinations of calendar trades we can create some very specific trade profiles to take advantage of complex situations. A common use is to trade the gap from earnings announcements.

Trade Analysis – LULU Earnings Stock LULU is announcing earnings on the 7th before the market opens The weekly option expires that afternoon and its IV is very high – 117% The Oct options have a far more normal IV of 54.4% This looks like an interesting opportunity

Frame the Trade We want to take advantage of the very high IV on the short term options while protecting ourselves from any extreme price movements caused by the earnings announcement. Our plan is to create a pair of complementary calendar trades on each side of the stock’s current price, allowing us to make a solid profit over a range of prices and limiting our risk in case of a large gap from the earnings.

Estimate the Gap An estimate of the potential price gap from the earnings announcement can be created by analyzing the prices of ATM options. Use the option that expires just after the earnings announcement. The estimate of a 1 standard deviation price movement up or down is based on the value of the options; Est. Gap = (ATM Call Price + ATM Put Price) – Distance of Price from Strike LULU @ $65.19 65 Call @ $3.30 + 65 Put $3.05 – (Price $65.19 – Strike $65) = $6.16 Gap

Choose the Strikes We want to choose strike prices for the trade that are wide enough it is unlikely the stock will gap outside them We also want tighter strikes for higher profit potential The Gap Estimate is normally a good starting point In this case I am going to go slightly inside the gap estimates and use strikes of 60 and 70

The short side Sell short the weekly 70 Call for $1.19 IV of 111.11% Theta of $0.35 Vega of -$0.022 Sell Short the weekly 60 Put for $1.37 IV of 133.70% Theta of $0.39 Vega of -$0.021 This creates a Credit of $2.56

The Protection What expiration should we use for our protective trades? Looking for the least expensive protection possible What will the value of these options be when we sell them? Drop in IV will happen, but how much? We know how long we are likely to hold the trade – theta erosion?

Estimate IV after Earnings The IV of all options increases prior to earnings, but the IV of options that expire further in the future are affected far less. Look at the IV of the option expiring 3 or more months in the future and this will give you a sense of normal levels of IV. Look at the history of IV in this stock and see what normally happens after an earnings announcement. Based on the evidence I am estimating that the IV of the LULU options will drop to 46% after the earnings announcement.

Cost of Protection We need to determine the difference in price between when we buy the protection and when we sell it. Things that will change Theta erosion will over the period we hold the IV will drop after the announcement These reduce the value of the long options In this analysis we are assuming that the price doesn’t move up or down – middle of the road worst case

Protection – Sept Exp Buy Long the Sept 70 Call for $1.89 IV of 64.50% Theta of -$0.096 Vega of $0.052 Buy Long the Sept 60 Put for $2.08 IV of 72.34% Theta of -$0.105 Vega of $0.048 This creates a Debit of $3.97 Cost Analysis Hold 7 days – Theta loss of (0.096 + 0.105) * 7 = $1.407 IV will drop to ~46% Call: (64.5% - 46%) * 0.052 = $0.96 Put: (72.3% - 46%) * 0.048 = $1.26 Total cost of Protection = $3.62 (hmmm, not so good)

Protection – Oct Exp Buy Long the Oct 70 Call for $2.89 IV of 51.72% Theta of -$0.050 Vega of $0.0881 Buy Long the Oct 60 Put for $2.95 IV of 58.30% Theta of -$0.052 Vega of $0.081 This creates a Debit of $5.84 Cost Analysis Hold 7 days – Theta loss of (0.05+ 0.052) * 7 = $0.714 (better) IV will drop to ~46% Call: (51.7% - 46%) * 0.088 = $0.50 Put: (58.3% - 46%) * 0.081 = $0.99 Total cost of Protection = $2.20 (not too bad)

The Trade Sell short the weekly 70 Call for $1.19 Sell Short the weekly 60 Put for $1.37 Buy Long the Oct 70 Call for $2.89 Buy Long the Oct 60 Put for $2.95 This creates a Debit of $3.28

P&L Profile

Breakdown We make the most money if the price is near the 60 or 70 Strike near expiration Possible to make 50%+ return in short period of time Between the strikes we will make money but not as much Trade risks: The stock gaps significantly outside our strikes (some buffer on that) The IV drops further than expected

Plan Enter the trade several days before earnings Watch the P&L before earnings If we get a 20% return exit early (no risk, lock in the money) If the stock moves to either of our strike prices exits early Risk is getting higher Should be no more than a small loss and possibly a small profit After earnings we let the short options expire Close the long positions near the end of the day on expiration Friday

Calendars Recap Calendars are great tools to play both time erosion and IV changes They can be joined with other calendars to make a trade with a wide profit range Some complexity The value of the protective side often determines how profitable the trade is Need to analyze using the Greeks