In Times of Low Volatility, You Have to Get Creative ...

I've been active for almost two months now, due mostly to the lack of volatility across the markets but also due to personal reasons. Most of my experience in tradin options is in strategies that are utilized in times of high IV. The rest of it is in directional swing trading. However, directional opportunities are hard to spot and scan for, plus their PoP is inherently 50%. High IV strategies fare much better, but not when IV is low!

So now I'm experimenting with calendar spreads in paper trading. Calendar spreads involve selling a call or put in a month closer to expiration while simultaneously buying a call or put (correspondingly) in a month further from expiration at the same strike. This allows the spread to benefit from the passage of time and the increase of volatility over the life of the short leg. While PoP may initially be low, as IV increases, PoP also increases. This is because the back month long leg benefits more from an increase in IV than the front month short leg is harmed by increasing IV. Calendar spreads are also delta neutral, but can be tailored to be slightly delta positive or negative. This is done by "mismatching" the strikes. For example, instead of selling the July 200 and buying the August 200 call, one would sell the July 98 and buy the August 102 call, thereby collecting a credit instead of paying a debit and therefore profiting from down moves in the underlying.

Observe these risk profiles:

The top profile is of a calendar and the bottom is of a bearish diagonal. Which one to choose depends on risk tolerance and on your directional assumption. Calendars require less capital than (credit) diagonals because calendars are debit spreads, meaning their maximum loss is capped. This is not so for a credit diagonal, and therefore at the expense of higher PoP, diagonals require more margin ~ about double that of a calendar.

You may be asking, "if diagonals collect a credit AND have a slightly higher PoP, why not always use them over calendars?" The answer is that diagonals have a very close break even point to where the current underlying is trading, so you are in effect trying to pick the peak of a move and catch a downswing. If the underlying moves much higher, you're sunk. In addition, because of the strike and expiration mismatch, the effects of the delta and gamma cause the price of the spread to vary more than does a calendar on a day to day basis. If after a week you decide that you in fact did not call the top, the spread would be trading at more of a discount to your cost basis than would a calendar, of which the price of the spread does not vary much over the course of time.

For these reasons, it would be wise to use calendars over diagonals most of the time, unless the underlying is significantly overbought or oversold. (as measured by Bollinger Bands and RSI correspondence). And even then, it might be more advantageous to just buy a put spread with a 50% PoP rather than sell a diagonal, but that's up to you whether you want theta on your side, which depends on your view of the velocity of the potential downswing, and if you think vol will expand significantly enough to warrant the extra margin.

OK this is getting complicated. Basically, it's best to remain delta neutral as much as possible unless otherwise signaled by measurements of price. Ergo, calendars > diagonals in most situations. Both are outmatched by the iron condor, however, it is unwise to trade iron condors in times of low IV because they benefit from contracting IV, not expanding.