Market Volatility is Extremely Low, What Are You Doing to Protect Yourself?

With the S&P 500 approaching 1300 and the VIX at extremely low levels it can be difficult for those that trade iron condors and other strategies that incorporate verticals in its structure. It’s at these points that a high probability trader needs to think about hedging some of the volatility risk that is inherent in the market right now. With so many option trading strategies it can be difficult to pull one out of the hat. However, a particular option strategy that can capitalize on rising volatility is a calendar.
The construction of a calendar is pretty simple. All you do is sell a front month option that still has about a month left before it expires and purchase another option with more time at the same strike price. Calendars are either done as calls or puts, not both. If a call calendar or a put calendar is setup at the same strike price it is essentially the same trade. Thus, whether a put or call calendar is used is based upon which would be out-of-the-money. So if the stock is at $50 and a $47 strike is chosen, one would generally go with a put calendar. If a $53 strike is chosen one would generally go with a call calendar.
Calendars are a difficult for many people since they don’t understand how they make money. Since you’re buying and selling the same strike price the intrinsic value doesn’t come into play. Essentially the cost of the calendar is the difference in extrinsic values for the front and back month options. As a result, a profit is achieved as the difference in the time values between the back month option purchased and the front month option sold increases. There are a few ways for this to happen. One way is through the passage of time. Since the shorter dated option sold decays at a faster rate than the option bought, calendars have a positive theta. Also, since the back month option is affected more by changes in volatility, an increase in volatility evenly across both expiration months will cause the difference in extrinsic values to increase. Thus, calendars have a positive vega, meaning they want implied volatility to increase. Lastly, calendars profit as the stock moves toward your strike price since the at-the-money options have the greatest amount of time value. As a result, the difference in extrinsic values for the options traded increase, and increasingly so as you approach expiration.
Since calendars make money as the stock approaches your strike price, as time passes, and as implied volatility increase, the management of calendars should reflect this. A calendar is managed through buying back the front month, short strike close to expiration and then selling the next expiration month. This process is called rolling. While it is optimal to roll close to expiration, that rule assumes that the stock is somewhere in the vicinity of the strike price chosen. If the strike chosen moves deep in-the-money or far out-of-the-money enough to cause the theta to almost turn negative it may prompt you to roll early to prevent a max loss.
With all of the option trading strategies to choose, understanding what matches your outlook for the direction of the underlying and implied volatility can help improve your odds and increase profits.