Hedge Volatility Fluctuations with ETF Calendar Spreads

As Wednesday’s pause showed once again, rallies continue to run into profit-taking and uncertainty. One day the Dow is up 400 points; the next, sideways fizzle (if not down 300 points). We condor traders don’t care how long the market jerks back and forth - the weaker the trend, the better. But, as we noted in Wednesday’s post, the iron condor isn’t the only strategy we can use in sideways markets.

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Members who have been following our March 25 Real Estate ETF (IYR) bonus trade already know how nicely calendar spreads can work in this environment. Calendar strategies complement iron condors well because they have positive vega - i.e., they benefit from rising implied volatility, balancing out the volatility risk of the negative-vega iron condor. Of course, we always choose our condor trades carefully - taking implied volatility into account as we look for the right strike prices, on the right underlying, and the right time to trade - to achieve our 10% target profit. Nevertheless, a few calendar spreads are a nice way to hedge the volatility fluctuations along the way.

ETFs make for good calendar spreads, because they tend to move less than individual stocks, and any sudden, event-driven move on the part of one component is smoothed out by the overall portfolio of components. These three ETFs look like pretty good calendar-spread candidates at the moment:

• iShares MSCI Emerging Market Index ETF (EEM) - Trading near the middle of its ten-week trading range, the ETF is meeting resistance at the 200-day moving average, with support from the 10-, 20-, and 50-day averages all within five points; implied volatility of the June 140 calls is within 0.5% of the May 140 calls.
• iShares Dow Jones US Real Estate ETF (IYR) - Still a good candidate, but now it’s time for the May/June spread. Today IYR is breaking above its March high, but there’s resistance right overhead at the 200-day moving average; the 50-day below provides support at 64.54. The June 69 call’s implied volatility is within 2 points of the May 69’s; IV is near the bottom of a 5-month range.
• Energy Select Sector SPDR ETF (XLE) - Up against downtrend resistance, with resistance from December highs above at 80; support from 20-, 50- and 200-day moving averages within four points. The May 77 calls are trading at a slight volatility premium compared to the June 77 calls. (Note: Use caution with this one - current implied volatility, at the middle of its 3-month range, is not as low as we’d like it to be.)

The usual disclaimer: These examples are primarily for your entertainment and enlightenment. Don’t even think about risking real money unless you have experience managing calendar spreads under all kinds of crazy, unexpected conditions. If you don’t know what to do if EEM drops to 130 next week, just walk away, friend - just walk away.

Comments

[smokey888:]

What does this mean:
"Calendar strategies complement iron condors well because they have positive vega"

"they benefit from rising implied volatility, balancing out the volatility risk of the negative-vega iron condor"

2008 Apr 07 12:55 AM