This market has surely been a crazy one. It has been a difficult one for many of our portfolios that do best if the market is flat rather than gyrating all over the place. But right now, option prices are such that new spreads promise to do exceptionally well, especially if the market manages to settle down a bit.
Today I would like to discuss an important feature of buying calendar (or diagonal) spreads.
Finding an Implied Volatility Advantage
When market professionals talk about the Implied Volatility (IV) of a particular stock or ETF, they are referring to the at-the-money current-month put and call options for that underlying instrument.
While it makes total sense that every option for a particular underlying should have the same IV, in reality it is usually not the case. Some options are more expensive than they “should” be and others may be cheaper than they “should” be.
When I was a market maker on the CBOE, one of my favorite tactics was to find discrepancies in IVs of options on the same underlying, selling the “over-priced” options and buying the “under-priced” options. I would try to maintain a neutral net delta condition at all times so I didn’t care whether the stock went up or down while I waited for the market to correct itself and move the IVs of both sets of options closer to parity. (I surely wasn’t alone in using this tactic, as it was, and still is, one of the most widely-employed strategies on the floor.)
The 10K Strategy that we carry out at Terry’s Tips involves buying LEAPS (or other longer-term options) and selling short-term options (sometimes Weeklys) against them. If the long and short sides of the spread are at the same strike, it is called a calendar spread, while if they are at different strike prices, it is a diagonal spread.
In the best of all possible worlds, we would seek out underlying stocks where the LEAPS carried a lower IV (so they were “cheaper”) than the IV of the short-term options (which were more “expensive”). Whenever we enjoyed this difference in IVs, we know that we have an IV Advantage.
Most of the portfolios that we carry out at Terry’s Tips use SPY as the underlying, in spite of the fact that there rarely is an IV Advantage for that ETF. It is more likely to be found for individual company options, especially when there is a rumor or earnings announcement coming soon, as short-term options often see unusually high IVs in anticipation of such events.
At the present time, the short-term options for SPY carry a higher IV than do longer-term options. The August options that expire this Friday carry an IV of 36 while SPY options expiring in January 2013 have an IV of only 28. This would be a perfect time to place the kind of calendar spreads that are the basis of our most popular strategy.
While having an IV Advantage stacks the deck in your favor, it should not be used as a sole determinate in choosing an underlying instrument to trade options on. It is possible to make good returns with the 10K Strategy when you don’t enjoy an IV Advantage, but it is extremely helpful whenever option prices make it possible.