Written by A.J. Brown

ATM Calendar Spreads, Aware of the Gotchas?

Calendar Spread TimerOver the years of being both an options trader and trainer, I have seen different option strategies that come into and out of vogue. It seems almost cyclical, like fashion.

For me, every option strategy has its time and place to be traded. I look at each option strategy as a tool for an application. Rather than trying to apply a single tool to every situation, I prefer to assess the situation and pick the right tool.

With that said, I am seeing a lot of emphasis right now on at-the-money (ATM) Calendar Spreads. I thought it would be worthwhile to steal some insights from our Trading Trainer Academy program and bring attention to some hidden gotchas that, if not accounted for, could turn a highly profitable ATM Calendar Spread into a big loser.

First, what are ATM Calendar Spreads? ATM Calendar Spreads are sometimes called ATM Time or ATM Horizontal Spreads. They are constructed by buying an at-the-money option with an exercise or expiration date farther out-in-time. Then, selling an at-the-money option (with the same exercise or strike price as the option bought) with an exercise or expiration date closer-in-time. They can be constructed with either put or call options. The idea is to profit on an underlying stock that is channeling horizontally by capitalizing on the difference between the rates of option time decay.

The image below shows that the closer to expiration an ATM option gets, the faster the rate at which the option value changes.

ATM Time Decay

The ATM Calendar Spread profits based on the difference between the rates of time decay of the option bought that expires far out in time versus the option sold that expires closer in time.

ATM Calendar Spreads profit, at first glance, so long as an underlying stock stays within a certain range. The image below shows an example of a underlying stock’s price chart to the left and an ATM Calendar Spread’s profit and loss diagram to the right.

Calendar Spread P&L

The gotcha associated with ATM Calendar Spreads is that an investor might not factor in the affects of implied volatility changes (option traders call this the “Vega Risk”). I’ve looked over the shoulder of some ATM Calendar Spread traders, and have been surprised, if not alarmed, that they’ll factor in the underlying stock price range and the difference in time between the two options and leave it at that.

Implied volatility is a factor in an option’s price. The higher the volatility is, the higher the option price will be. Higher implied volatility develops because the market expects a big move on the underlying stock price either up or down. Let me emphasize that volatility does not predict direction or even specify that a directional move will happen, it is just the expectation of how far a potential move could take that stock price.

The image below shows an example plot of implied and historical volatility over a year period.

Historical and Implied Volatility

It turns out that even though our primary focus for profiting from an ATM Calendar Spread is the difference in option time decays, the strategy is actually much more sensitive to changes in volatility.

An increase in implied volatility will cause a “volatility rush” in the ATM Calendar Spread, causing the amount of profit to grow and the range the underlying stock must stay within to profit, to be larger. These are both good things.

Conversely, a decrease in implied volatility will cause a “volatility crush” in the ATM Calendar Spread, causing the amount of profit to shrink and the range the underlying stock must stay within to profit, to be smaller. These ramifications are not good at all and can actually take a potential winning trade and make it a loser.

When investors look for underlying stocks to trade ATM Calendar Spreads on, they look for those that they expect to trade in a narrow range for the next 30 to 45 days. The gotcha is if they stop there. It’s imperative that they also evaluate implied volatility.

Because implied volatility has a tendency to revert back to its mean, I advise to look for implied volatility to be in the lower 25% of its yearly range. I also recommend comparing the implied volatility of the two options being considered for the ATM Calendar Spread. If anything, you want the option you sell that is closer-in-time to have a higher implied volatility than the option you buy that is farther out-in-time. This is called having a positive implied volatility skew.

By assessing implied volatility and implied volatility skew, an ATM Calendar Spread trader can set themselves up for not only profiting, but also potentially realizing a “volatility rush” that will only add probability of an increase to their winning.

In summary, ATM calendar spreads are trades that have a high profit probability and a favorable reward-to-risk. However, if the trader does not factor in changes in implied volatility when considering the trade, a calendar spread that seems a dream at the time the trade is being considered, may turn into a nightmare as the trade progresses along.

Keep doing ATM Calendar Spreads, but be sure to analyze the implied volatility. Specifically, trade calendar spreads with low historical volatility at the time the trade is being considered and look for positive implied volatility skew.

To your good trading.

A.J. Brown

8 Responses to “ATM Calendar Spreads, Aware of the Gotchas?”

  1. William @ 12:40 am:

    Currently trading extreme options (Weeklies) in a program offered by Price Headley of Big Trends. Very brief swing trades, usually only overnight. First quarter of 2011 I’ve had 13 of 15 winning trades. Only negative: too few trades possible to consider it other than as a spending-money income source. I chose it for budget reasons and for meeting my goal of doubling my Jan. 1st entry acct. balance of $5000. I’ve only accumulated $2000 in gains, which statistically reads well. The current whippy market does not favor this strategy at the moment, despite it’s success record. Too few trades for the price of admission. $500 subscription fee has enabled me to gain but $2000. That makes my overhead 25%: $500 cost to gain $1500 net. So, I don’t know if I will renew 2nd quarter or not.

    Any suggestion welcome.

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  2. Jay @ 8:45 pm:

    Thanks for the info AJ. Clear and understandable

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  3. Mark Lewis @ 9:35 am:

    AJ, I must say, this is the most practical and compact piece I have ever read on Calendar Spreads. I appreciate how you cut through the theory and get to the heart of the matter - the information I need to pull the trigger and make the trade. A metaphor that came to mind as I read is that time decay is like Google maps telling you the average drive time, and volatility is the traffic. You need *both* to plan out the trip. And, timing the traffic where the artistry exists. Voliaility is the name of the game! Thank you.

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  4. elandivar2000 @ 12:02 pm:

    AJ,

    Good work in helping us understand how implied volatility can be our friend if used properly in an ATM calendar spread.

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  5. Lyric Ginsberg @ 2:27 pm:

    This is such a profound piece on a part of options trading that I never imagined. Understanding how to make the most of volatility and trade with that as a tool in the toolbelt gives me more “options” and ability to know when and in what trade to pull the trigger. Without this information I would not attempt these type of ATM trades.
    Thanks AJ!

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  6. VN @ 1:10 pm:

    HI AJ

    Thanks for the post. It makes things clearer. I was wondering if adopting to play this for earnings would be good. What I mean is to have a earnings month as a far out month and the current month as the near one where you sell your option. This could work for those stocks that are volatile during earnings release. Also it would be good to realize the profits as close to the earnings date as possible. Let me know what you think. With all due respects to have money management controls taken care off.

    Regards

    Vijay

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  7. davey @ 1:02 pm:

    This is definitely one of the best explanations i’ve seen on this topic. every time i read your blog i find the info to be quite useful and well thought out. thanks for pointing out the pitfalls.

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  8. Tina Collins @ 12:16 pm:

    AJ.

    Thanks for writing about calendars. I have been studying this strategy for over a year. I have found the best stocks to trade calendars are WMT, PG, PEP, KO and surprizingly GLD. I am using low ATR and low Beta as part of my scan as well as IV. Like you said about 25% or lower.

    One of the biggest challenges for me is where in the channel is ideal to enter a calendar. Any thoughts on this? I am guessing the middle since that is where the risk graph would be optimal.

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