Term Structure Arb

A calendar spread uses different EXPIRATIONS at the same strike. A vertical spread uses different STRIKES at the same expiration. Calendar trades term structure (time); vertical trades direction and/or skew.

More time means more things can happen - more uncertainty. The market charges a premium for longer-dated insurance. Also, short-term IV tends toward realized volatility, while far-term remains uncertain, supporting higher IV.

Maximum loss is the debit paid. If you pay $100 for the calendar, you can't lose more than $100. This makes calendars defined-risk, suitable for TFSAs.

At-the-money, call and put calendars behave similarly due to put-call parity. Slightly OTM, choose based on skew - often put calendars benefit from selling richer OTM puts. Most traders use calls for simplicity.

Your short near-term option expires (worthless if OTM, or assigned if ITM). You're left with the long far-term option. You can either sell it, keep it, or sell another near-term option against it (rolling).

Typical approach: near-term 21-45 DTE, far-term 45-90 DTE. The near-term should be long enough to collect meaningful theta but short enough for decay to accelerate. Far-term should be significantly longer but not so long that it's illiquid or ties up capital.

Earnings cause stock gaps that can move the stock far from your calendar's strike, causing significant losses. Additionally, the IV crush post-earnings affects both expirations in ways that may not benefit the calendar. Enter after events, not before.

It depends on your view. Calendars are delta-neutral (no directional view). Diagonals have directional bias. If you expect the stock to stay put, use calendar. If you have a directional lean, diagonal lets you express both time and direction.

When near-term is expiring, buy back the short option and sell a new short option at a later expiration. If stock has moved, you may need to adjust the strike too. Rolling collects more premium but extends your time in the trade.

Small moves are OK - calendars have a profit range. Large moves hurt because both options become delta-dominant and the theta differential collapses. The ideal is stock stays near strike; significant movement reduces or eliminates profit.

Forward Variance = (T2×Var2 - T1×Var1) / (T2-T1), where Var = IV². This gives the market-implied variance for the period between T1 and T2. If forward variance seems extreme vs history or expectation, a trading opportunity may exist.

Use reverse calendars when: (1) Term structure is in steep backwardation and you expect normalization (near-term crushes), (2) You expect a large stock move (reverse calendar profits from movement), (3) You want short vega exposure. Note: requires margin due to naked far-term.

Term structure is one dimension of the volatility surface (time). Skew is another dimension (strike). The full surface shows IV across all strikes and expirations. Expert traders analyze the entire surface for relative value, trading combinations of term structure and skew.

Model scenarios: (1) Term structure inverts sharply, (2) Term structure flattens, (3) All IVs spike together, (4) Stock moves to various levels. For each scenario, calculate position P&L. Ensure you can survive realistic worst-case scenarios.

Approximately yes. ATM calendars at delta-neutral strike isolate term structure from direction. To isolate from overall IV level changes, you'd need to balance vega across positions. In practice, pure isolation is difficult but approximation is achievable.