Introduction
Forward volatility trading can be an extremely lucrative strategy. In this article, I will walk you through my personal journey of identifying and executing a forward volatility trade last month using calendar spreads. Inspired by Professor Jim Campasano’s research, we’ll explore how the market’s volatility expectations throughout time created a lucrative trading opportunity.
I wanted to share this trade because the edge was pretty clear, and it’s a good example to learn from. However, we need to start from the beginning to understand how to think through trades like these.
I’ll give you the context for this trade – the research I’ve done and the things I learned that helped me spot this trade.
Then, I’ll walk through the trade analysis that made me realize I found a good trade.
I’ll also discuss how I structured, sized, and managed this trade.
Intro to Forward Volatility
This trade is a forward volatility trade. Forward vol is fairly complex but can be illustrated in several examples.
If a stock’s weekly and monthly options have an implied volatility of 30%, assuming the market expects a constant volatility of 30% throughout the month makes sense.
However, something is up if the weekly option has an implied volatility of 50% while the monthly option still has an implied volatility of 30%. The market must expect a lot of volatility in the first week of the month. However, since the monthly option remains unchanged, weeks two to four must be fairly calm.
We can figure out using math if the first week has a volatility of 50% —but the stock has a volatility of 30% over the entire month—that weeks two to four must have a volatility of 19%. In other words, the forward volatility from weeks two to four is 19%.
Trading Calendar Spreads
A calendar spread involves selling a short-term option and buying a longer-term option of the same strike. In this example, we can sell the weekly and buy monthly options to structure a calendar spread. If the implied volatilities are correct, this trade should have an expected value of 0. During the first week, the stock realizes 50% volatility. In the first week, the weekly option (50% IV) breaks even, and the monthly we bought at 30% IV makes gamma profits. However, the monthly option’s implied volatility should drop to 19%, reflecting that the next few weeks will be calmer. The monthly option should break even since gamma profits are lost to IV Crush.
Trading opportunities can arise if the market expectations for volatility in the future are inaccurate. For example, if the market is pricing in 50% vol in the first week and 19% vol for the rest of the month, we have a calendar trade opportunity if we know the stock will realize a constant 30% volatility throughout the month. We will profit from selling the weekly option at 50%, as the stock only realizes 30% volatility in the first week. Meanwhile, the monthly option we sold at 30% breaks even on gamma. At the end of the week, the calendar spread makes a profit, only losing money if the IV of the monthly option falls below 19%.
Jim Campasano’s Research
Jim Campasano — a former hedge fund manager and currently a professor of finance —wrote a research paper documenting how forward volatility is a terrible indicator of future implied volatility. In times of stress, the market tends to overestimate short-term volatility so much that forward volatility becomes far too low. In other words, calendar spreads profit unless the long-term option experiences an extreme amount of IV Crush.
A portfolio of calendar spreads on the most backwardated (liquid) stocks keeps up with the returns of the S&P500 – but with much lower volatility.
We can press our advantage further as retail traders – we get to be pickier about our trades! Rather than just slapping on this trade systematically, we can wait for the best opportunities. We’re not a hedge fund that’s always required to have specific positions. If we don’t like any trade, we don’t have to take any of them.
However, a particularly juicy trade came along last month…
Background
It’s Monday, March 13. Silicon Valley Bank collapsed over the weekend, the Feds had to step in, and the markets were spooked. KRE — the S&P Regional Banking Index ETF — had implied volatilities at all-time highs. It seems the regional banking sector would either collapse soon or everything would stabilize, and life would continue as usual.
The short-term 11 DTE implied volatility was 105%, but the longer-term 39 DTE IV was about 72%. Forward volatility from 11-39 was 55%, much lower than the implied volatility of either expiration. Buying a calendar spread (selling the 11DTE, buying the 39DTE) was an interesting trade.
Trade Analysis
For this calendar spread, I will now refer to a short 11 DTE option position as the short option. I will refer to a long position in the 39 DTE options as the long option.
If KRE realized a volatility of 105% over the next two weeks, the short option would break even. However, my long option will earn gamma profits, as I purchased the option at an implied vol of 72%. My calendar spread would only lose money if implied volatility for the long option fell to 55%, a drop of nearly 20 points.
If KRE volatility underrealized, my short option would profit from theta. My calendar spread would only lose if the IV of my long option drops far enough to erase those gains. If KRE exploded, however, implied volatility for my long option would increase, hedging the losses of my short option.
From Jim Campasano’s research, we can assume that forward volatility is too low; the calendar spread is likely profitable since the long option experiences less IV Crush than the market expects.
Trade Structure
I bought several Mar24/Apr21 $45 put calendars for around 90 cents. Because calendars are a debit position, sizing my trades becomes easy. My max loss for these trades is the premium paid. Since my risk is capped, I also tend to delta hedge less (or not at all). This reduces my costs in exchange for more variance.
Why not just sell vol?
In Jim Campasano’s research, he does actually mention that it’s typically the short-term volatility that is overpriced. However, simply selling a short term straddle is a significantly riskier trade. If the regional banking sector collapsed, the short straddle would explode. Meanwhile, a calendar spread would take some gamma losses but would be partially hedged by the long-term option.
When we buy a calendar spread, we’re expressing that short-term volatility is relatively expensive compared to long-term option prices. The risk-reward seems better for this trade compared to an unhedged short-vol position.
Another consideration is that calendar spreads are debit positions. Short straddles require a lot of margin for retail traders, whereas calendar spreads don’t. You could easily slap on five other calendar trades without impacting your buying power too much.
Results
By Friday, short-term volatility had fallen to 99. On the other hand, forward volatility rose to 67%. Because I mistakenly thought there would be a dividend the following week, I closed my calendar spread so I wouldn’t have to deal with the adjusted strikes, lower liquidity, etc. If I had known that there was no dividend, I would have held onto my position a little longer, since the term structure was still backwardated and the trade was still +EV.
Ultimately, I closed my calendar spread for $1.25, or a 39% gain. However, remember that there’s a lot of variance in these trades. There will be trades where the entire calendar spread goes to 0.
Lessons Learned
Throughout this trade, I was reminded of several key lessons.
Firstly, trading the relative prices of options effectively minimizes overall market risk, allowing us to navigate volatile environments with greater confidence. Had I sold straddles instead of buying a calendar spread, I would have still made money, but it would have cost me a lot of margin – and several nights of good sleep!
Secondly, reading academic papers offers a treasure trove of potential trading strategies, providing valuable insights that can enhance our trading toolbox. Most proven, successful retail trading strategies are not original. However, there’s no shame in “borrowing” ideas from others. Plenty of trading firms do the same things with slightly different implementations.
Finally, the importance of diligent research cannot be overstated; being aware of events such as dividends, earnings, and stock splits is essential to making informed decisions and maximizing our chances of success. Had I not panic closed my positions because I thought I missed an upcoming dividend, I probably would have earned much more in this trade.
In conclusion, forward volatility trading using calendar spreads can offer a profitable strategy with lower risk, as demonstrated by my experience and Professor Jim Campasano’s research. Consider adding forward volatility strategies to your portfolio today!
