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

3. 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.

4. Basic Example of a Calendar
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

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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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.

13. 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

14. 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.

15. 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 $ $ Put $3.05 – (Price $65.19 – Strike $65) = $6.16 Gap

16. 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

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

18. 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?

19. 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.

20. 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

21. 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 ( ) * 7 = $1.407
IV will drop to ~46%
Call: (64.5% - 46%) * = $0.96
Put: (72.3% - 46%) * = $1.26
Total cost of Protection = $3.62 (hmmm, not so good)

22. 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 ( ) * 7 = $ (better)
IV will drop to ~46%
Call: (51.7% - 46%) * = $0.50
Put: (58.3% - 46%) * = $0.99
Total cost of Protection = $2.20 (not too bad)

23. 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

24. P&L Profile

25. 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

26. 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

27. 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