Long Gamma – How to Make a Long Gamma Position Work for You
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Calendar spreads, also known as time spreads, are extremely versatile strategies and can be used to take advantage of a number of scenarios while minimizing risk. A calendar spread consists of buying or selling a call or put of one expiration and doing the opposite in a later expiration.
More often than not, this involves buying or selling an option in the front month the expiration closest long gamma short vega options trading the current date and selling or buying an option of the same strike either the next month or a few months out.
They can also be done using weeklies instead, especially around events. Call or put calendar spreads look alike on a graph of profit and loss. A calendar spread is considered long if you buy the later month option and short if you sell the later month options. Since later month options have more time value and cost more, you will pay for a long calendar spread and receive money for a short time spread.
Your maximum loss until the first expiration on a long calendar spread is the cost of the calendar spread. If stock moves too far and the strike is either way in-the-money or way out-of-the-money the time value of the spread will go to zero as the options will be worth the same amount, either parity or zero.
In a long calendar spread you are short gamma, positive theta and long vega see section on greeks. Therefore, you want the stock to stay still and the implied volatility to go up. Does that sound unlikely? It need not necessarily be so, but the calendar spread does require some refined thought about what your expectations are for an underlying.
At-the-money front month options decay the most as expiration approaches. If stock stays still the long calendar spread allows a trader to benefit from that decay as he or she is short the front month option without being naked short an option.
If you think the implied volatility in a front month is outsized to the movement you expect in that month and if you think the implied volatility in a later month is trading low given that there are potential events upcoming, then you might put on a long calendar spread to take advantage of this implied volatility skew.
If you are correct than implied volatility will come in on the front month option plus time decay. You can buy it back or wait for it to expire and own the later option at a good price. You could use that later option as the first leg of a spread. An example from the site in CSCO here. With a short calendar spread, you are long gamma, negative theta and short vega.
You want stock to move, but implied volatility to come in. In this case you would want to be long gamma, but it is going to be expensive as the implied volatility is high. By selling a time spread, you can take advantage of the near term volatility while minimizing cost and with the expectation that the later month implied volatility, if it is trading higher than historical, has a good probability of coming in.
This is a nice strategy in long gamma short vega options trading market conditions where everything has been jittery. The gamma of the front month option protects you from near term movement and yet the short vega of the longer term option allows you to sell high premium while allowing time for it to come in. The danger of a short calendar spread is that after the near term option expires you are left naked long gamma short vega options trading an option. We will talk about taking off calendar spreads below.
The calendar spread can also be used as a directional play. On the site we have used the long calendar spread for stocks going into earnings. The best case scenario is if the stock moves to that strike and then, since the event has happened, it stays still until expiration. Ideally, if implied volatility was not as elevated in the later month as in the front month then the implied volatility will collapse much more in the front month than in the later month.
In this case, you can see how the calendar spread still made money, but not as much. Also note the thought process that went long gamma short vega options trading when to take off the spreads. Many people have asked about why to use a calendar spread as directional play as opposed to a call or put spread.
In general, calendar spreads take advantage of horizontal volatility skews. Some of this can be based on market-wide conditions. On the other hand, if the VIX is low, then in the case of a specific event there might be a nice skew between the event month or week and later months.
Owning vega at historically low levels is a lower risk proposition and the high implied volatility in the front option is likely to come in after the specific event in a placid market. Will the decay in the front month long gamma short vega options trading beat the collapse long gamma short vega options trading vega of the back month call? This depends on how still the stock stays and how pumped up the later month may have been by the event.
There is always the option of keeping the spread on past expiration and being long or short an option. Perhaps with a long call spread you are confident that you have bought the later option at a good price and that implied volatility will go up. You might want to hold on to it or even use it as the first leg of a call or put spread.
Long gamma short vega options trading a short time spread you are left naked short an option after the first expiration so risk is unlimited unless you leg into a spread. Other things to keep in mind with calendar spreads are long gamma short vega options trading which may happen between the two option expirations and changes in short interest rates. Make sure that your inputs are correct and up-to-date and beware of hard-to-borrow stocks as the possibility of a changing short interest rate and buy-ins can change the value of the options disproportionately.
This gives you a rough estimate. For more information on estimating implied event moves not near expiry, please see our post on the subject. Reasons to put on a calendar spread: Calendar spread as directional play The calendar spread can also be used as a directional play.
Reasons to Put on a Calendar Spread. Calendar Spread as long gamma short vega options trading Directional Play.
Back-of-the-envelope calculation for implied move.