When trading a calendar spread using equity options, the most that you can lose is that amount of money you pay for the spread. However, when looking to trade VIX calendar spreads this is not the case. The reason you have a larger amount of risk is that different /VX futures trade independently to one another.

Today, Tom Sosnoff and Tony Battista look to put some numbers around this problem. The guys find out that 14% of the time the loss on the calendar was higher than the debit paid. This is a great example of how even though you are buying a calendar spread, the unique nature of the product has additional risks!

Tony B: Thomas, we're back my friend. Market Measures. You got manye-mini S&Ps a little off their lows. We're down $4.00 now, trading $21.06. Jacob did his job again on Thursday, bringing the market a little bit lower. We got Nasdaq down a $1.50. It was up all day. Russell down a $1.80. Dow only down $7.00. Still got a tight inside day. [inaudible 00:00:27] nice movement down 10, oil down a $1.20.
Tom S: Yeah, I like the fact that [inaudible 00:00:32] stock's down.
Tony B: Mm-hmm (affirmative). Apple down $1.68 or so, $1.70. Between 127.10. Good move in there too.
Tom S: Yeah.
Tony B: Serum's come down a little bit. Helps the position a little bit, trading 69.
Tom S: Yeah. We hope to loosen a lot.
Tony B: Home Depot has had a nice move down, down 85 cents. Again, I'd like a little bit more.
Tom S: All this stuff helps. Okay. Every little bit helps. I'm just looking through all the positions right now. Freakin' Netflix is up three-and-a-half dollars. Is there a wall there too?
Tony B: Oh yes. If Apple's down you must put the money into Netflix.
Tom S: [chuckling 00:01:20]
Tony B: That's the wax off part. The wax on [crosstalk 00:01:21]
Tom S: Very good, grasshopper. Okay. I'm just going through everything. It's so funny, right? Serum back down to $69.
Tony B: Mm-hmm (affirmative).
Tom S: Would've been nice to wait, but what are you going to do?
Tony B: It'll be fun just showing that it's not what you do.
Tom S: I know. It's funny because the one time you wait, the next thing you know the stock's 73. Hopefully it's okay today. It would be nice if we could get a little downside fall. It'd be really nice if they could break…
Tony B: 15 points? To start them off. Yeah. Why not?
Tom S: 15 points, for sure.
Tony B: Hopefully 15, 26.
Tom S: Yeah. Maybe they caught all the Apple freaks. Caught them red-handed. Let's hope. All right. We have a phone segment coming up. Let me go back.
Tony B: Meanwhile, the Nasdaq's down a $1.00.
Tom S: You've got to know.
Tony B: You've got Apple losing $40 billion over the last couple days that it just created? Come on.
Tom S: It just dropped $7.00
Tony B: Mm-hmm (affirmative).
Tom S: That would be nice. What was that call spread we did in there? What's the 30, 31 call spread? I think we sold it for 48 cents. Is it worth taking a look at.
Tony B: I'll look at it right now.
Tom S: I don't mind covering that and getting into something else.
Tom S: 40, 41 call spread
Tony B: What spread was that?
Tom S: It was the…
Tony B: 132, 130 [crosstalk 00:02:57] sold yesterday.
Tom S: No, it was only…
Tony B: It closed.
Tom S: No. It's the 130, 131 calls. It's 33 cents. Still too high. We sold it for 48. Got to make a little bit more money on it.
Tony B: Okay.
Tom S: Okay. All right, let's do it. Man, we go so much stuff to do.
Tony B: Mm-hmm (affirmative).
Tom S: It's been great. I love Jacob. I think I can have him on the show every single day. Every single day. I don't think I would ever get tired of being challenged by him. Ever. Some good news…
Tony B: What are you doing over there! Don't break the place!
Tom S: Some good news. We have two more skinny segments coming up.
Tony B: Mm-hmm (affirmative).
Tom S: TP is going to do a segment called, "The Skinny on Option Modeling." And Dr. Jad is going to do a segment, it's called, "The Skinny on Data Science."
Tony B: Everybody's getting skinny in here but me and you.
Tom S: Everybody's getting skinny, that's right.
Tony B: [chuckling 00:03:57]
Tom S: Yup. Jules's going to do a segment on Girl Scout Cookies. Fun. Jules. Skinny on the Girl Scout Cookies. You're so scary right now.
Tony B: Yeah!
Tom S: We got a segment right now which his called VIX calendar spreads. I'm pretty sure that this is going to be a tough one for them to pull off, but I know what they were trying to do and I'm fascinated by that part of it.
Tony B: Mm-hmm (affirmative).
Tom S: A strategy we consider in low volatility environments is a calendar spread. Remember, this segment is designed to be a learning experience. Designed to be learning. We're not doing VIX calendar spreads.
Tony B: Mm-hmm (affirmative).
Tom S: You guys all know the dangers of VIX calendar spreads, but we want to actually show you the numerical side to it. By the way, one error. I kept saying that the show this Sunday that I'm doing is at 6:00 o' clock; it's at 7:00 o' clock. It officially starts at 7:15 but we want to basically start a few minutes early if we can get all filled up before then. So, 7:00 o' clock this weekend on Sunday night.
Tony B: Mm-hmm (affirmative).
Tom S: Liz and Jenny, I think it's 1:30. I'm at 7:00 o' clock Sunday night.
Tony B: You're at 7:15.
Tom S: Right.
Tony B: You're at 7:15 [crosstalk 00:05:04]
Tom S: But we're going to try to start at 7:00. So we're done by 8:30. That's what I want to do. A strategy we consider in low volatility environments…
Tony B: But it says 7:15 to 9:15.
Tom S: I understand.
Tony B: Okay.
Tom S: But I want to do it from 7:00 to 8:30, so we'll see what we can do.
Tony B: Got it.
Tom S: A strategy we'll consider in low volatility environments is a calendar spread.
Tony B: Mm-hmm (affirmative).
Tom S: The trade is generally constructed by selling a near-term call or Put and buying a longer-term option at the same price. We've done calendar spreads all over the place and we already know you can't do it in the VIX. On normal equities, calendar spreads are defined risk trades, as the max loss for a calendar spread is the debit that you pay for the trade. However, there are certain products which this is not the case. The VIX is one such product. You'd be surprised to know there are other products out there where calendar spreads can get a little bit funky. The SPX is one of them for deep in the money calendar spreads, but we're not going to go there yet, okay? The SPX is one of them as well. Very deep in the money. For now, we're just going to focus on the VIX 'cause it's the most prevalent of all the underlying products where calendar spreads can get you in a heap of doo-doo.
Tony B: [inaudible 00:06:24]
Tom S: VIX options are traded under the same ticker. Each cycle of VIX options is essentially its own product. That's how you have to kind of think. Each VIX expiration is some time in the future that we're hoping something happens to the volatility. Either it contracts or expands but it all has to take place prior to a specific date.
Tony B: Mm-hmm (affirmative).
Tom S: All right. In effect, a really good way to explain the VIX is: each cycle of VIX is its own product since VIX options are priced off of the VIX future with the same expiration month. This changes the risk profile of calendar spreads entirely. It's a really good way to explain it. In order to demonstrate this using real numbers, we decided to test a mechanical calendar spread strategy in the VIX. I'm not sure that everybody always grasped the way we explained it before. Here's the study. We went back to June of 2008 to present. We went to the day of VIX settlement which may or may not be the right thing to do but, again, very hard to do anything outside of settlement. Bought the first out of the money based on the front forward slash, front slash call calendar.
Tony B: You really wouldn't be able to do it any other way in VIX 'cause you wouldn't be able to tell…
Tom S: It's hard.
Tony B: What any of these spreads would be trading for.
Tom S: We shorted a call expiring in 27 to 34 days. We recorded the P and L on the close before the VIX settlement. Here was something interesting. With VIX call calendar spreads, doing it one time for 78 months starting in 2008, it was the only underline we could find where you're actually down money. Down money.
Tony B: Mm-hmm (affirmative).
Tom S: 50% of the time of we win. Average credit, average debit, whatever.
Tony B: Yup.
Tom S: Biggest loss over debit? $636. If you're talking about the average debit being a dollar and you're talking about biggest loss being $6.36, then there's, essentially, kind of how you measure risk reward.
Tony B: Mm-hmm (affirmative).
Tom S: Just remember, net P and L down. Based on the results, 14% of the trades resulted in losses greater than the debit paid. In one example, the calender spread was $1.57 and ended up being a $794 loser. Another example, the calendar spread was 20 cent credit, ended up being a $290 loser. I've actually seen way worse situations, but the takeaway from the segment is, with respect to VIX calendar spreads, that 14% of the trades resulted in losses greater than a debit paid. I have a lot of firsthand experience with this and the first thing we did… And these numbers are very accurate, because the first thing we did when we ran the brokerage firm was we went back and we studied…
Tony B: Reverse engineered?
Tom S: Reverse engineered what our brokerage firm risk was in the VIX. We reverse engineered all our risk in the VIX, and we found was that for a typical trade, whether you put on for a credit or a debit, whatever it was…
Tony B: Mm-hmm (affirmative).
Tom S: We figured out the risk over time was about $700.
Tony B: Yeah, you were talking about this with Chris on the pitch yesterday.
Tom S: Mm-hmm (affirmative). We figured out the VIX calendar risk was $700. This is a perfect example to go back to what Jacob was just talking about a second ago. Some firms don't allow you to do this at all and some firms, they allow you, but you have to put up a lot of money.
Tony B: Sure.
Tom S: We said, "Okay, you can do this. Put up $700."
Tony B: [chuckling 00:10:17]
Tom S: It's the solution to every problem, it's just, "You covered the risk. Do whatever you want." Correct? It's a stupid trade.
Tony B: Why do you think your car insurance is $500 a year? Because it's probably only worth about $400. Or it's worth $100. I don't care what it is. Whatever the numbers, it's worth less than $500.
Tom S: Yes. The statistical value is about $125 and then you have to put on whatever the administrative costs are on top of that, so double it to $250.
Tony B: It's less than $500, that's all I know.
Tom S: It's a straight 100% mark-up.
Tony B: Mm-hmm (affirmative).
Tom S: What's cool about this is we were able to put a numerical number of $700 around this discussion of what risk is. Then we charge you $700 for every [inaudible 00:11:09]
Tony B: [chuckling 00:11:09]
Tom S: So now, it's up to you.
Tony B: Right.
Tom S: That's all it is. The reason I wanted to do this so bad is because I wanted to show you that you can find a situation which is the worst trade you can make from a calendar spread. The absolute worst. But rather than say to people, "Don't trade this," just put a dollar number out there where it says, "This is what it costs to trade."
Tony B: Now you can make a decision if you want to do it or not.
Tom S: That's exactly right.
Tony B: On your own use of capital.
Tom S: That's right.
Tony B: Mm-hmm (affirmative). Now the risk is yours, I collect my commission, and I'm done.
Tom S: Yeah. We've lost $5.8 million in 2007. $5.8 million in customer losses from VIX calendar spreads and most other firms lost similar amounts of money.
Tony B: Mm-hmm (affirmative).
Tom S: Some lost $3 million, some lost five, some lost 10, whatever it was, but this was the biggest industry loss. A lot of it was just because the legacy clearing systems didn't understand what real risk was around calendars.
Tony B: Mm-hmm (affirmative).
Tom S: VIX calendars. They didn't know what real risk was around VIX. Any time you get a situation where 14% of trades result in losses greater than debit paid, that's a little nervous.
Tony B: Yeah.
Tom S: That makes you a little nervous.
Tony B: Sure.
Tom S: Okay.
Tony B: And rightfully so.
Tom S: SMPs are down 275. The Nasdaq is up $4.00.
Tony B: I was worried about the Nasdaq there for a moment. [chuckling 00:12:26] Went red for a second.
Tom S: I know.
Tony B: I thought something was horribly wrong.
Tom S: I heard you were worried.
Tony B: [chuckling 00:12:31]
Tom S: We were worried that you were worried.
Tony B: You were worried for me?
Tom S: Yeah.
Tony B: Take a quick break, we'll come back! We got Good Trade, Bad Trade next. You're listening to tastylive Live.