Term Structure Arb

Not pure arbitrage - it's more like 'relative value trading.' True arbitrage is risk-free profit. Term structure trades have risk: stock can move, term structure can move against you. It's 'arbitrage' in the sense of exploiting mispricings between related instruments.

Maximum loss is the debit paid to enter the position. This occurs if the stock moves far away from the strike (both options go to near-zero or intrinsic). In practice, you'd likely exit before this point.

Calendar spreads have maximum value when the stock is at the strike. At-the-money, time value is highest, and the decay differential is greatest. When the stock moves away, both options move toward intrinsic value, reducing the spread value.

Yes, if there are multiple expiration months with sufficient liquidity. Major stocks like DBS, OCBC, UOB, and STI options typically have monthly expirations. Check liquidity before trading.

Buying calls/puts is directional (betting on stock movement). Term structure trading focuses on the relationship between IVs at different expirations. You can profit from term structure normalization even if the stock doesn't move much.

Look at IV for ATM options at different expirations. Calculate: Far Month IV - Near Month IV. Track this over time. If current slope is much higher or lower than typical, you may have a term structure opportunity.

It depends on your goal. If you bought the calendar TO capture earnings IV crush, yes. The front month IV will crush more than back month. But if the stock gaps significantly, the calendar may lose. Size appropriately for the event risk.

Common choices: 30-day front / 60-day back, or 45-day front / 75-day back. The key is enough time differential (30+ days) for decay differential to matter. Too close (7-day spread) has limited benefit; too far (90+ day spread) ties up capital.

Calendars are same strike, different expiration - pure term structure + theta. Diagonals are different strikes AND different expirations - adds directional and potentially skew exposure. Use diagonal if you have a directional view alongside term structure view.

Close when: (1) 50-75% of max profit achieved, (2) Stock moves significantly from strike, (3) Front month approaching expiration (5-7 days), (4) Term structure thesis achieved, (5) Stop loss hit. Don't hold to expiration - manage actively.

Market makers track vega by expiration bucket, not just net vega. They hedge parallel shifts with ATM options and term structure exposure with calendar spreads. They set limits on term structure exposure and may hedge with VIX futures if available.

Forward variance is the variance implied for a future period (not from today, but between two future dates). Calculated from term structure: σ²_forward = (T2×σ2² - T1×σ1²)/(T2-T1). If forward variance is extreme, it may indicate mispricing in a specific period.

View the volatility surface as 3D (strike × expiration × IV). Term structure can vary by strike - OTM puts may have different term structure than ATM. Analyze both dimensions together. Trade opportunities where surface is 'kinked' or extreme.

Persistent anomalies can result from: (1) Structural hedging demand (covered call selling keeps near-term call IV low), (2) Supply/demand imbalances in specific expirations, (3) ETF/structured product flows, (4) Market maker positioning. Not all 'mispricings' will correct quickly.

Requires historical IV data across multiple expirations - harder to obtain than spot data. Must account for realistic execution (bid-ask spreads on calendars can be wide). Consider earnings dates and events. Test out-of-sample and be cautious of overfitting.