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