What is it about a calendar spreads opposed to other spreads (e.g vertical spread) that makes it such a popular strategy for a period of low implied volatility?

Is it that when low volatility turns around and increases, somehow the long leg is supposed to increase in value while the short leg is supposed to remain unaffected or (even better) decrease in value?


The main thing to keep in mind with all these different option combination strategies is that you are really trading option greeks! I think the answer to why the calender spread is so popular lies in the special combination of gamma and vega risk:

Calendar spreads are the one type of trade where gamma can be negative while vega is positive (and vice versa of course). That means that while it is a an implied vol play you are still getting compensated for holding gamma risk (see variance risk premium). So while you are hoping for higher implied volatility you certainly want low realized volatility!

So putting it all together what you are hoping for is that while complacency should fade away (implied vol increase) there should still happen nothing really exceptional (low realized vol). This might be the way a lot of traders view many low vol environments (if they really understand what they are trading there which might not always be the case ;-)

If I may I would recommend a very good book on the subject:
Trading option greeks by Dan Passarelli

In that book you find everything about calender spreads on pages 201 ff.

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    $\begingroup$ Thank you. Is realized volatility the same as historical volatility. I will come back to read your answer after i read the book you mentioned...are there other good books on topic of Greeks? I find it hard to understand. $\endgroup$ – Victor123 Feb 25 '15 at 15:48
  • $\begingroup$ @Victor123: Historical vol is the realized vol over a given time period. If you really want to dive into the matter you have to start with option pricing theory. Two very basic, yet good books are the following: books.google.de/… and books.google.de/… $\endgroup$ – vonjd Feb 25 '15 at 16:03
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    $\begingroup$ Thanks...i started with sheldon natenberg...i will check out your recommendations. thank you! $\endgroup$ – Victor123 Feb 25 '15 at 16:04

Calendar spread is popular because it is versatile. A long calendar benefits from theta decay no matter what. Meanwhile, an investor enters into a calendar spread when a skew in volatility between front month (expensive) and farther dated months (cheaper) is favorable. In other words the terms structure of options is good for the long calendar owner. So an investor has two ways to profit either from quick volatility return to to normal or more paced theta decay.

Another attractive property of a calendar is it is hard to lose 100% of your investment. The underlying must make a very substantial move to wipe out a long calendar spread completely.This has nothing to do with theory or option pricing but it is an important practical consideration, which I am sure does make the spread more popular.

  • $\begingroup$ Thanks. How much of a downmove is required in the underlying to lose 100% of the premium paid in a calendar? I can't figure it out,damn! $\endgroup$ – Victor123 Feb 26 '15 at 2:52

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