Calendar Spreads: The Hidden Options Strategy Traders Use for Profit

[00:03] professionals, the top hedge funds, use this all the time to bet on volatility. And if you're new to this channel, my name is Alex Monahan. I used to be a quantitative trader, a market maker, trading derivatives at Susuana, one of

[00:19] the top trading firms. And we were trading against hedge funds, big institutional players. And some of the sharpest, smartest hedge funds are using calendar spreads all the time to bet on volatility and to bet on events. So if

[00:34] you want to make money trading options, having an understanding of calendar spreads, when to use them, how the pros are using them is absolutely critical. So in this video, I'm going to start with the basics. What is a calendar

[00:48] on it. What are the pros and cons of calendar spreads? And then I'm going to get more strategic. How are pros? How are hedge funds using calendar spreads to profit in derivatives markets? How are they executing calendar spreads?

[01:03] What are some things to note? So, I really hope you enjoy this video. Comment any questions, comment other video ideas for me. I love making trading content as well as sports betting content. So, what exactly is a

[01:15] calendar spread? It's very simple. You're buying one option and selling one option, but the options have different expiration dates. Typically, they have the same strike price. So, usually you're selling a shorter term call

[01:27] option or a put option and you're buying the longer term option. So, time between expiration dates can vary, right? You could buy a twoe call and sell a oneweek call. Same strike price. There's also diagonal spreads, which means the strike

[01:43] prices are different. You could sell an at the money call expiring in 1 month buy, you know, a 30 delta out of the money call option expiring in 3 months. spread. But when you are trading calendars, what you're essentially doing

[01:58] is you're renting out a shorterterm option and then you're getting long Vega. You are getting long volatility. So if you don't know what Vega is or the options Greeks, I've made some tutorials on them. So here's a full tutorial on

[02:12] the option Greeks. the four main ones, gamma, delta, vega, theta. So, it's really important obviously to have an understanding of the Greeks if you want to make money trading derivatives. So, what are some of the pros of calendar

[02:25] first of all, if you want to be long Vega, it is obviously cheaper to put on a calendar spread versus just buying an option outright. Because when you put on a calendar spread, you're selling a cheaper option. Expiration is closer, so

[02:40] it's a cheaper option, but you're collecting premium. So that kind of offsets the cost of your long call or put option. So it's cheaper. That's one of the reasons that people like calendar spreads. Second reason people like

[02:53] calendar spreads is you have much more defined risk than just obviously selling options outright. So for example, let's say you think earnings is overpriced. Implied volatility is too high around earnings. You'll see a lot of hedge

[03:07] funds, a lot of really smart people putting on calendar spreads around events like product announcements, earnings, things like that. If you just sell options, you think the shorter term options are overpriced. If you just sell

[03:20] options, you theoretically have unlimited risk. If the stock soarses options, you theoretically have unlimited risk. Although you'll probably be margin called, but you get the point. So, one of the reasons that people like

[03:34] your short option, you're winning on your long option. So, another interesting thing about calendar spreads is you are long Vega and you're long is you are long Vega and you're long theta. So, usually when you buy a call

[03:47] option, you are long Vega, you are long volatility, but you are short theta. Every day that goes by where the stock isn't moving, you're losing money. So what's very interesting about calendar spreads and why people like them is you

[04:00] are long time decay. The optimal thing is the stock price doesn't really move until expiration and the short option expires worthless and then you still have value in your longer term option. So the nice thing is you are long theta

[04:14] and you're also long Vega. So you benefit from time decay and you also benefit from you know increases in implied volatility. So very briefly, let's go through a quick example of a time spread. We're selling an at the

[04:27] money call option, one week expiration, one week till expiration on Tesla, and we're buying the twoe call. So what you'll notice is I'm long approximately 70 cents of Theta on this trade. So every day that goes by, assuming, you

[04:42] know, all other factors stay the same, I'm making approximately 70s. I'm also long about 15 cents of Vega. So if the implied volatility of Tesla increases, I'm winning on this trade as well. Now, one thing I do want to mention though is

[04:55] you are short gamma. When you are long time spreads, you are short gamma, which you can see in delta is approximately the same for both options. So if Tesla, if the underlying stock goes up by a dollar or down by a dollar, it doesn't

[05:08] really impact me. So that is kind of how the Greeks work with time spreads. So how does this relate to the cons, right? What are the cons of putting on time What are the cons of putting on time spreads is if implied volatility drops,

[05:21] you're losing money because you're long Vega. Another risk because of gamma, you're short gamma, is if the stock starts to move too much. If the much, you're short gamma, you are going to lose money. But the final risk,

[05:34] especially for retail traders, is the bidass spread. There are studies that have shown that commissions and the spread that market makers charge, that's the main reason why most day traders lose money, right? There's literally

[05:47] studies that have looked at millions of traders accounts and have shown this. The bid ass spread, the market maker fee, essentially the difference between the bid and the ask price. That's the reason most people end up losing money

[05:59] stupid. It's not because they're always picking the wrong thing. It's basically the bid ass spread over the long run that eats into your profits. So when you're putting on a calendar spread, obviously there's two options. So the

[06:12] bidass spread, the fee essentially to put on the trade is going to be higher than just selling a, you know, a call option or buying a call option. So you can of course use a calendar spread if you just want to be long Vega. However,

[06:25] most of the pros, the very smart financial players like hedge funds, they are using calendar spreads or time spreads to bet on particular events, right? So, every company has things that move its stock price, right? Or have the

[06:40] potential at least to lead to massive moves in the stock price. Earnings is of course very common, but for drug companies, it can be, you know, drug panels or studies coming out. So for example during COVID there were times

[06:55] when there were panels about you know the vaccine where Fiser stock the near-term options were so expensive that they were implying the implied volatility of Fizer that Fizer was going to move 10% within 2 weeks. So depending

[07:11] on the industry depending on the company there's very different things that can impact its stock price. But what you'll oftent times see is these very smart hedge funds like Citadel, Millennium, what they'll do is if retail investors

[07:24] bid up earnings near-term, you know, volatility, so call options close to expiration around earnings, what they'll do is they'll sell the rich fall or the expensive shortterm expiration date options and they'll buy the cheaper

[07:40] backmonth vault or the longer term options. So, that's a very common trade, especially when earnings volatility is very bit up and there's a massive, you know, implied price move priced into these short-term options. That is a very

[07:54] common trade. But again, it's not just earnings. People talk about IV crush and earnings volatility because again, every public company has earnings. However, there's so many events that can impact the price of a stock. And as an options

[08:08] trader, whether you're a retail trader selling or buying or if you're a market maker, it is critical. Like when I was at Susuana, we would spend all day thinking about event volatility. What could we be missing that could move the

[08:23] price of airlines? So I traded Jets, which was an ETF kind of encompassing all of the airlines, United Airlines, American Airlines. So I would constantly be thinking, what can move the price of Jets? There's obviously earnings. is

[08:37] what are other things that relate to airlines that may move the price. So, let's go back to the example of the time spread we looked at earlier, the 1724 one. So, we're selling the near-term call expiring on the 17th and we're

[08:51] buying the call option, same, you know, strike price, but one week later expiration on the 24th. So, if we are buying this time spread, you're actually buying earnings volatility, right? Earnings is on the 22nd. So the first

[09:07] option by the time we hit the expiration date you know earnings hasn't happened so earnings doesn't affect it. However the second option if the stock price moves massively right we would benefit on this time spread. We want Tesla if we

[09:20] put on this time spread we want earnings to go crazy and the stock to soar 15%. That would be the best trade in the world. So basically what you can do is you can look at the difference in implied volatility for these two

[09:33] options. So for the option expiring on the 17th that doesn't include earnings, it's 56%. Whereas for the option expiring on the 24th that does include earnings, you know, expires the Friday after earnings, it's 71.5%.

[09:49] options only are a week apart, it's 15.5% higher. So the question is, is that too low or is that too high? If we are long this time spread, we think it's too low. And this is how hedge funds think, right? They're like, they'll do

[10:04] think, right? They're like, they'll do all these models and you can too. Why is it only 15.5%. Maybe you think your model thinks it should be a 25% that were the case, you'd want to be long this time spread. You'd want to put

[10:18] it on yourself. However, if you think it's should be only 10%, you want to sell this time spread. You want to buy the near-term option, sell um the option expiring right after expiration. So, long story short, this is how hedge

[10:31] funds are thinking. every event they are thinking what is the market missing there's currently a 15.5% difference in implied volatility around this major event is that too low or is that too high and you can think about it yourself

[10:46] too what is the market missing you look at the difference in implied volatility around events product launches drug trials what is the market missing you have to remember financial markets are overall relatively efficient especially

[10:59] for a company like Tesla where there's There's literally millions of people looking at the stock price every single day thinking about its upcoming earnings. The market's pretty efficient. So my gut tells me probably 15.5% is the

[11:13] correct number. However, for less efficient markets, right, small cap stocks, you may be wrong. Sometimes you can find mispricings. Obviously, the bid ass spread is going to be higher for, you know, options on more liquid stocks.

[11:28] a killing with time spreads and it's not only in options markets. I mean, there's hedge funds who made billions of dollars during COVID with energy trades, oil futures. So, people are constantly thinking about where is the market

[11:43] mispricing events or where is the market missing an event, right? Implied volatility between these two expirations is the same, but they're missing this they're missing this thing that could massively impact the underlying stock.

[11:56] So that is what hedge funds are thinking about, right? The difference in implied volatility around events or where is the market not pricing in events that should be priced in. So time spreads are amazing for betting on events. You can

[12:09] been the greatest trade of all time. If you were on time spreads from January to March of 2020, that's when COVID took off and volatility surged, which means option prices got much more expensive. The VIX is basically just a measure of

[12:25] implied volatility or how expensive are options. So, I mean, people have made a killing in spreads, time spreads. Definitely something to consider if you whether it's stocks, whether it's commodities. Now, one thing I wanted to

[12:40] mention about time spreads, this more applies to the implementation of time spreads, is if there's a hedge fund who's really smart, essentially what event, right? They want to buy the volatility, let's say, of Tesla

[12:53] earnings. They could just call all the market makers. They could call Goldman Sachs, Morgan Stanley, and say, "Hey, we want to buy a ton of these time spreads." However, you're also alerting the market makers of your trade, right?

[13:06] really smart, the market is going to put weight into that. You're essentially alerting them. You're mispricing the event volatility. You are mispricing people do because they don't want to alert the market makers who are just

[13:21] then going to take up their event volatility which as a trader at Susuana constantly thinking about event vault. How do you have certain events priced? And you are constantly evaluating is it too high, is it too low and where are

[13:35] these smart hedge funds or toxic flow? Where are people trading? Are they buying the event or is they are they selling the event? You're looking at market data, order flow from, you know, not as much retail traders, people in

[13:49] their Fidelity or Robin Hood account, from really smart institutional traders, they're trading in the market to determine if you're pricing things fund in the world just keeps loading up on the event volatility, you may have it

[14:05] price it higher or at least increase your bid ass spread. But long story so I apologize, but it's really important to consider. What you'll see a lot of people do is they don't literally call you and say, "I want to put on a

[14:19] time spread or a calendar spread." What they'll do is they'll sell the shorter term V first and then they'll leg into the longer term V. So, they kind of disguise their trades. They don't call you and say, "Hey, I'm betting on this

[14:32] event." They'll sell some options to one market maker and then they'll sell some more. they'll kind of load up on the position in a more discreet way that makes it harder for the market makers to identify what they're trying to do. And

[14:45] aware of that and you're constantly trying to sus out what all these different trades in the market mean from really smart financial players. So, for example, if I'm a market maker, if someone keeps putting on time spreads on

[14:58] United Airlines for earnings, a very smart hedge fund, I may consider ticking up, increasing the implied volatility. If I'm an American Airlines derivatives trader, I may consider increasing the implied volatility of American Airlines

[15:13] going to be a bigger move than I initially thought. So you're constantly looking at all this data order flow to inform your belief on what the event

[15:25] essentially the volatility of a specific day should be. So I hope you enjoyed this video on time spreads, calendar spreads, how to use them, how to think about them, how professionals, hedge funds are using time spreads to

[15:37] capitalize in financial markets. So yeah, thank you so much for your time,