Buying the Front, Selling the Back
All trading is based on the principle of “buy low, sell high”—even volatility
trading. With time spreads, we can do both at once, but we are not limited
to selling the front and buying the back. When short-term options are
trading at a lower IV than long-term ones, there may be an opportunity to
sell the calendar. If the IV of the front month is 17 and the back-month IV is
25, for example, it could be a wise trade to buy the front and sell the back.
But selling time spreads in this manner comes with its own unique set of
risks.
First, a short calendar’s greeks are the opposite of those of a long
calendar. This trade has negative theta with positive gamma. A sideways
market hurts this position as negative theta does its damage. Each day of
carrying the position is paid for with time decay.
The short calendar is also a short-vega trade. At face value, this implies
that a drop in IV leads to profit and that the higher the IV sold in the back
month, the better. As with buying a calendar, there are some caveats to this
logic.
If there is an across-the-board decline in IV, the net short vega will lead to
a profit. But an across-the-board drop in volatility, in this case, is probably
not a realistic expectation. The front month tends to be more sensitive to
volatility. It is a common occurrence for the front month to be “cheap”
while the back month is “expensive.”
The volatilities of the different months can move independently, as they
can when one buys a time spread. There are a couple of scenarios that might
lead to the back-month volatility’s being higher than the front month. One is
high complacency in the short term. When the market collectively sells
options in expectation of lackluster trading, it generally prefers to sell the
short-term options. Why? Higher theta. Because the trade has less time until
expiration, the trade has a shorter period of risk. Because of this, selling
pressure can push down IV in the front-month options more than in the
back. Again, the front month is more sensitive to changes in implied
volatility.