Calendar Spreads, best suited for low volatility option writing selling

In calendar spread, Option we Buy will always be costlier than the option we Sell.

Shubham Agarwal

Option writing has nowadays become one of the strategies one always does. While regular writers are most of the time disciplined, this helps in a very good strike rate.

However, when it comes to the premium earned by selling options, nowadays the returns are significantly less. The slow-moving (Low Volatility) and positive-toned market has less risk perception. Less perceived risk among traders means that expected volatility is less. This directly results in lower premiums. There are two problems with this.

1. Lower premium on the investment of margin (we require to pay margin to write option)

2. Spike in the risk perceived could kill the Option writer.

The second point is also a risk. Perceived risk (volatility) has a tendency of being range bound. This means that if we are at the lower end of the range, we may move up. When there is a spike in perceived risk it leads to a rise in premium without any change in price. For a seller of options, this poses a big risk.

Calendar spread lets an option writer Sell options and at the same time reduce these two risks tremendously.

What is Calendar Spread?

In a calendar spread, one would buy a longer-term expiry contract and sells a nearer-term option with the same strike price and same option type. This is popularly known as buying a calendar spread. The option we Buy will always be costlier than the option we Sell in this case. We end up paying premium, hence Buy Calendar spread.

If the Buy and Sell action is interchanged in this options trading strategy then it is called Sell Calendar Spread.

How does the Buy Calendar spread help?

1. Now that we are Buying one Option against selling the other, the Margin will be much lower. On the other hand, we will be buying an Option against sold option but the Sold option being close to expiry will fall with the passage of time faster than the option bought. This is a characteristic that will make us money.

2. Once again, since we have an option that is bought against the one that is sold, we are covered if the perceived risk goes up. Any rise in premiums will be almost the same for all the options of the same index or stock. This will reduce the impact of a rise in premiums significantly.

3. Lastly, imagine a slow-moving market that gets a big gap down or a big rise. This case will make the option writers lose significantly. In this case, the most one can lose is the net premium paid with the calendar spread strategy.

Things to keep in mind:

1. Implied Volatility or IV is what describes the perceived risk that we have talked about. IV for an option is nowadays publicly available information. One is better off trading in options where nearer term options IV is higher than that of longer-term expiry option.

2. Closer to expiry this strategy makes better returns, so this is best suited to be traded in weekly expiries.

Thus, to continue writing with a reduced risk in lower volatility times Calendar Spreads is a better option.