Calendar Spreads and Volatility
Some of today’s underpriced calls are underpriced because the underlying has been so volatile over the last 100 days. An example is CIEN, whose measured 100-day volatility is 112%. This high volatility reading is due to a few large moves, and in such cases you should be aware that an option purchase that counts on this volatility reading means you are betting that such large moves will occur again in the underlying before expiration of the option you are trading. In CIEN’s case, moves greater than 10% have been occurring at the rate of about two per month.
This brings up the question of the reliability of the historical volatility as an estimate of future volatility, which I will discuss at a later time.
Most of today’s calendar spreads (our name for long time spreads) involve selling the March contract, which is natural because the March options are about to expire and are experiencing their greatest time decay, but be aware that a calendar spread is a stability spread and can suffer from large moves in the underlying. Its maximum profit occurs if the underlying closes at expiration precisely at the strike price, and profit drops off in both directions from there. You certainly want to monitor any calendar spread position closely.
A calendar spread benefits from an increase in implied volatility, so if you expect the underlying’s options to experience such an increase soon (before expiration of the short leg), this is an additional attraction not considered in the Cost/ThVal comparison.