Questions about Calendar

[OptionsTrader]

I have started paper trading Calendars based on the rules (Mojo’s and Sheridans) posted on this website. I am struggling to make sense of the Skew entry rule. The rule states that “ If IV of short position is less than IV of the Long position, then their difference should be less than 2 and if IV short is greater than IV Long then there difference should be less than 4. Here is my attempt at making sense of this rule,

a) IV short < IV Long: In this senario, the current month volatility is less than the future month. Hence the market thinks that the underlying’s volatiltiy is going to go up in the future and therefore the underlying’s price is going to go down in the future. We limit this to a 2 because we want the price to stay the same or change very slowly.

b) IV short > IV Long: In this scenario, the current month volatility is higher than the future month and therefore the market expects the price of the underlying to go up. We limit this to a 4 for the same reason as above.

c) I don’t have a good reason for the difference of 2 between the limits in a) and b). Could it be that price could move down faster than up.

I am new at this so i would like to invite your comments. Let me know if i am way offbase.

[Mojo]

… I love calendars.

The rule you are stating actually comes from Sheridan. As I understand it he meant it to serve for two purposes:

1. to provide an edge when trading calendars by selling what's expensive (the higher volatility of the front month) and buying what's cheap (the lower volatility of the back month).
2. to provide a warning for calendar traders that they should look more closely at any difference in volatility greater than 4% (which would usually indicate a specific news announcement like earnings, merger, FDA approval, etc.)

I think your interpretations are on base and will serve you well moving forward. I will still occasionally trade calendars that have a negative skew (i.e. the front month volatility is lower than the back month) but I will watch that trade much more carefully.


If you like,go ahead and pick a new calendar set up and I will paper traded along with you.


Welcome to the board,


Mojo