Calendar Spreads And Implied Volatility

Note that GUC has some calendar spreads that were selling for less than half their value at the close today (see the Equities Underpriced Explosion List). So do CMGI and LCOS, but GUC’s are at-the-money (more on this in a future commentary).

The calendar spreads on our site are “long time spreads”–long a long-term option and short a short-term option with the same strike price. Because the long-term option is more sensitive to changes in implied volatility, it will gain more than the short-term option loses (and the spread will gain) if the implied volatility increases; it also will lose more if the implied volatility decreases (and the spread will lose).

The greater the difference between the expiration times, the greater the difference in the implied volatility’s effect on the prices of the two options, and thus the greater is its effect on the spread. If you own a calendar spread, you are “long implied volatility,” and the greater the time difference between the expirations, the more “long” you are.

For this reason, it is wiser to look for calendar spreads where you might expect the implied volatility to increase, which is to say, among the underpriced options where the implied volatility is known to be low. You should avoid calendar spreads in those situations where the implied volatility is known to be high, which is to say, in the overpriced issues.

You may notice that the Overpriced Implosion Lists do not generally produce many calendar spreads. This is as it should be. If you find an interesting calendar spread on one of the overpriced lists, you should consider it with caution. (The OEX is a special case, which I will discuss next week).

The Underpriced Explosion Lists contain underlyings where the Volatility Ratio is low, meaning the implied volatility is low relative to the historical volatility. But if the implied volatility is also historically low relative to its own history, the spread’s edge is even greater since there is a good likelihood the implied volatility will “revert to its mean” and increase.

Thus, it makes sense to compare the implied volatility not only to the historical volatility of the underlying, as we currently do with the Volatility Ratio, but also to its own recent behavior. You can make this comparison a number of ways, and I will later introduce charts on the site that show this analysis. For now, you should restrict your calendar spread attention to those on the Underpriced Explosion Lists.