This is a guest post by Derek Devore, an experienced options trader. Find out more about his OptionBoost Video Training Program at http://optionboost.com
One of my favorite structures when I’m evaluating a position which is slow moving, but is on its way to reaching a particular price point, is Out of The Money Calendar Spreads, or “OTM” Calendar Spreads. In a Calendar Spread, one is basically selling the “front month” option while simultaneously buying an option further out in time – both options having the same strike price. The benefit to this spread is the fact that you are financing part of what you pay for buying an option, by the option you are selling in the spread. Lets look at an example:
Let’s say that the RIMM was currently trading at 28.00 and I thought it was going rally back to 31.50 by the end of this month. In this particular situation, I would look to purchase a Calendar spread at the 132 strike price by creating the following structure:
BUY +1 RIMM AUG 31 CALL for $0.99
SELL -1 RIMM JUL 31 CALL for $0.21
As you can see from the above order, I am purchasing the AUG Call (the month further out in time) for $0.99 and selling the JUL Call (the front month, or the month closest in time) for $0.21. So, collecting the premium of $0.99 and buying something else for $0.99, allows me to reduce my cost basis of the entire spread to only $0.78 (i.e.; $0.99- $0.21). Now, since we’re essentially selling something against something else we’re buying, we want to make sure that what we are selling is somewhat “overpriced” compared to what it has been priced historically. How do we best determine what is potentially overpriced in the options market?…with “Implied Volatility”!
Implied volatility is a measurement which tries to predict the future volatility (the magnitude of up-and-down movement in a security) in order to assign a theoretical price value for a certain option. In other words, if the underlying stock makes huge upswings and downswings, it is said to be more “volatile”. As expectations of future volatility increases, so does the implied volatility of a certain option contract, therefore its price generally increases and vice-versa. Therefore, going back to our Calendar spread example, we want to sell options that are overpriced (using its implied volatility as a measurement ) in order to buy options which we feel are fairly priced.
Charting Implied Volatility
Charting our two different-month options in a volatility chart quickly shows us that we are on the right track in terms of selecting this particular spread. If you notice in the chart below, the light green line (representing the July option we sold) is much higher than the dark green line (representing the Aug option we bought). Furthermore, you can see exactly where the 31 strike price lies on the chart, by the brown crosshairs – showing us that the implied volatility for the Aug option is all the way up to 49.89%, compared to the 44% implied volatility for the July option.
So it looks like we have indeed accomplished our goal of selling something which is relatively “expensive” to finance the purchase of something that is relatively “fair” in price.
Although this is just one aspect to consider when purchasing Calendar spreads, hopefully it will inspire you to dig a little deeper into implied volatility charts to allow you to see in a type of “third-dimension” of how pricing in the Option Market behaves – and more importantly – how you can learn to spot these pricing instabilities to use them to your advantage in your trading.
Derek Devore is an experienced options trader. He professionally trades his own account, from his home, specializing in Options Trading and Forex. He is the creator and owner of the OptionBoost Video Training Program at http://optionboost.com