Selling the Front, Buying the Back
If for a particular stock, the February ATM calls are trading at 50 volatility
and the May ATM calls are trading at 35 volatility, a vol-calendar trader
would buy the Mays and sell the Februarys. Sounds simple, right? The devil
is in the details. We’ll look at an example and then discuss some common
pitfalls with vol-trading calendars.
George has been studying the implied volatility of a $164.15 stock.
George notices that front-month volatility has been higher than that of the
other months for a couple of weeks. There is nothing in the news to indicate
immediate risk of extraordinary movement occurring in this example.
George sees that he can sell the 22-day July 165 calls at a 45 percent IV
and buy the 85-day September 165 calls at a 38 percent IV. George would
like to buy the calendar spread, because he believes the July ATM volatility
will drop down to around 38, where the September is trading. If he puts on
this trade, he will establish the following position:
What are George’s risks? Because he would be selling the short-term
ATM option, negative gamma could be a problem. The greeks for this trade,
shown in Exhibit 11.7 , confirm this. The negative gamma means each
dollar of stock price movement causes an adverse change of about 0.09 to
delta. The spread’s delta becomes shorter when the stock rises and longer
when the stock falls. Because the position’s delta is long 0.369 from the
start, some price appreciation may be welcomed in the short term. The stock
advance will yield profits but at a diminishing rate, as negative gamma
reduces the delta.