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Low Volatility Strategies

Richard Croft
April 24, 2011
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One option strategy that works well of you are in the “sell in May and go away” camp, is calendar or time spreads. It is also a good strategy in a low volatility environment. With the MX Volatility Index (VIXC) at 13.21 and below its 200 day moving average, we can say with clarity that volatility is low.

The calendar spread involves the purchase of a longer term call option combined with the sale of a shorter term call option. You could also use puts in a calendar spread, but the key with the strategy, is that both options have the same strike price.

You could create a calendar spread on the iShares S&P/TSX 60 Index Fund (symbol XIU, TSX, recent price $20.06) by selling, say, the XIU May 20 calls at 30 cents, and buying the XIU September 20 calls 90 cents. Both options are calls with the same strike price. The difference, and why we call it a calendar spread, is the expiration months.

The calendar spread has an out-of-pocket cost. You will always pay more for the longer call, than you will receive for the call you are selling. In the XIU example, the difference is 70 cents. For margin purposes, the call you bought effectively covers the sale of the short option. From a risk perspective, the most you can lose from a calendar spread is the net debit (in this example, $0.70).

What makes the calendar spread appealing is the certainly of time value erosion. The closer the option gets to expiration, the faster time value erodes. Eventually falling to zero, if at expiration, the option is out-of-the-money.

The value of the May options which expire in 4 weeks, will erode at a much faster rate than the September options expiring in 22 weeks. Almost twice as fast, assuming the underlying stock remains in a relatively narrow trading range.

If XIU is at or below $20 at the May expiration, this position will almost certainly be profitable. Why? Because at the May expiration, the September options will still have 18 weeks to expiry and assuming XIU at $20.00, would be worth about 80 cents. The net cost for the spread was 70 cents and you are now long September calls worth 80 cents.

The calendar spread is based on mathematical certainties. The time component within the options price will decline to zero at expiration. Further, since time does not decay in a straight line, the time value attached to the shorter option erodes faster than it does on the longer option.

But time value erosion is not the only thing that makes of this trade interesting. It is also attractive as a trade in a low volatility environment. Because, as volatility increases, it has a bigger dollar value impact on the longer term option.

For example, the prices used in the XIU example assumed a 13.21% implied volatility. But, suppose we applied say, a 20% implied volatility assumption to the options when the position was established (i.e. with XIU at $20.06 per share). At that volatility, the May 20 call premiums would have been 40 cents versus US $1.30 for September 20 calls. The difference being 90 cents.

There are risks of course. If the underlying stock should rise or fall significantly, the calendar spread will lose money. That’s because time takes a back seat to the relationship between the strike price and the underlying stock price.

If the stock were to advance sharply (assuming we are using calls to create the calendar spread), the short term option will rise at a faster rate than the longer term option. Eventually the calendar spread will start to lose money.

Ideally, with a calendar spread, you want the underlying stock to remain in a trading range, until the near month option expires. The XIU calendar spread should be profitable if the price of the stock remains between roughly $19.50 and US $20.50 until the May expiration. Above or below that range, the position will experience a slight loss, assuming volatility remains unchanged. But again, the potential loss is limited to the net debit paid.

Generally, you would not likely lose the entire net debit. As long as the September option had time remaining, it should have some value. Even if the underlying stock were to drop sharply, volatility would spike, which would benefit the longer term call.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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