A Great Time to Buy Calendar Spreads

Every once in a while, option prices are such that buying calendar spreads is particularly attractive. Now is one of those rare times.

Ideally, when you buy a calendar spread, you would like to buy the longer-term option when option prices for that month are "low" and sell a short-term option when those prices are "high."

What determines whether option prices are "high" or "low" is the Implied Volatility (IV) of the option. A "high" IV comes about when the market expects a stock will fluctuate a lot and a "low" IV results when the market expects the stock to be quiet.

For those of you who are mathematically inclined, IV is the average daily one-standard-deviation move of the stock, annualized. If the IV for the options on XYZ stock is 20%, the market believes that there is a 68% probability that XYZ will be within 20% of its present price one year from now; and there is a 95% probability of being within a 40% range of its present price one year from now.

When you can buy an option with a low IV and sell another in the same underlying which has a high IV, you have what is called an IV Advantage. You are essentially buying low and selling high at exactly the same time.

With the current extreme uncertainty in the stock market, short-term IV has skyrocketed. For example, IV for October 2008 at-the-money options on SPY carry an IV of 52% while SPY options that expire in March 2009 have an IV of only 30%. That is a huge IV Advantage.

Last Friday you could sell a SPY 110 October 2008 call (when SPY was selling for $110) for $4.50 (and there were only 13 days of remaining life for that option). You could buy a 110 March 2009 quarterly call for $10.30, or slightly more than double that amount, and this option had 179 days of remaining life.

In this example, the average decay rate of the option you are selling is $34.62 and the average daily decay of the option you buy is only $5.75. The spread would cost you $580 to buy (plus a $3 commission), for a total of $583. Each day the stock remained relatively flat, you would gain the difference in the decay rates ($28.87 although it would be greater than that because the March option would decay at less than the $5.75 average for the next couple of months).

In other words, if the stock stayed flat, you would earn almost 5% a day on your investment!

Of course, the stock will not usually stay flat, even for 13 days, so you would have to buy calendar spreads at several different strike prices or employ other spreads for protection against volatility as we do in our Mighty Mesa strategy, but this example gives you a general idea of the profit potential of buying calendar spreads at a time when there is such a large difference in the IVs of the shorter-term and longer-term options.

By the way, our Mighty Mesa strategy resulted in greater-than-50% gains for a single month in the September expiration for two of our six actual portfolios.

Finding calendar spreads with a huge IV Advantage is one great way to make exceptional gains in the options world if you know how to protect your spreads against any volatility that might result.

If you become a Terry's Tips Insider, you can see how we protect against volatility, and exactly how we did it in the above two portfolios last month.