Option writers are facing a challenging time with volatility keeping low, cutting premiums on selling options. In recent months, markets have been consolidating, making it difficult for them to generate profits due to low premiums. However, as elections approach and bullish signals hint at a market recovery, volatility is expected to rise.
Volatility is one of the major factors determining options' value. A low volatility index reading makes options cheaper, leaving smaller premiums available for option writers which makes sizeable profits difficult.
The question is which strategy should option writers use in the current market situation to earn profits? Also, which of the option Greeks must be targeted to improve the chance of profits?
Bhavin Desai, President, Quantsapp, said option writers face difficulties in both low and high volatility regimes. “Option writers desire to have a tepid volatility terrain or a low volatility regime but if one is expecting the volatility of the market to possibly move higher, then the option writer runs a Vega risk,” he said.
Vega measures the sensitivity of an option's price to changes in implied volatility.
Long calendar spread strategy
To mitigate this Vega risk and capture the Theta decay of option writing, Desai suggests using long calendar spread.
“Traders often employ this strategy to capitalise on the differential behaviour of option prices over time, leveraging the characteristics of Vega and Theta to generate potential profits,” he said.
A long calendar spread, also known as a time spread or horizontal spread, involves selling a near-expiry option and buying a far-expiry option of the same underlying asset at the same strike price.
Vega and Theta behaviours in long calendar spreads
In a long calendar spread, option writers expect to gain from the difference in the Theta decay of both options.
“The goal is to benefit from the relatively slower time decay of the longer-dated option compared to the shorter-dated one. As time passes, the shorter-dated option loses value at a faster rate than the longer-dated option, creating a potential profit for the trader,” Desai said.
On the other hand, the longer-dated option generally has a higher Vega compared to the shorter-dated option because of higher sensitivity to changes in implied volatility. Option writers can expect to benefit from this difference as well in a long calendar spread.
“Traders using a long calendar spread anticipate changes in implied volatility. If implied volatility increases, the value of the longer-dated option is likely to rise more significantly than that of the shorter-dated option. This differential Vega behaviour can result in a net gain for the overall spread,” said Desai.
What should traders do?
Traders should seek to enter the long calendar spread when implied volatility is low and is expected to rise.
As the implied volatility rises, the longer dated option's price is positively impacted by its higher Vega. The shorter dated option's price declines more rapidly due to its higher Theta, adding to the overall profitability.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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