Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 16. Calendar Spreads: Trading Theta and Vega

Market-neutral strategies and their close relatives—long-short, relative-value, and option-spread strategies—have long held out the promise of high returns, low drawdowns, and low volatility. These strategies tend to grow in popularity when a financial calamity results in both volatility and wider market spreads. Normally, a period of comparative market calm and stable correlations between markets follows, and at that point spread strategies appear almost too good to be true. Traders and investors alike envision hedged portfolios with fat spreads and a high likelihood of those spreads conveniently and profitably converging at expiration.

In the mid-to late 1990s there seemed to be a wide variety of funds that went down in flames while promoting such market-neutral strategies. These funds were based on studies of previous market-neutral programs and were backed by Nobel Prize–winning theorists using high-speed computers who scanned the globe for opportunities in market-neutral trading opportunities. In the end, each fund failed for one or more of the following reasons:

• A liquidity squeeze

• Too much leverage

• A fund manager's inability to meet margin calls

• A fund being short put contracts during a market correction

And yet, a new hedge fund would appear, fresh with someone else's cash, ready to pick up the baton and run with the same investment strategy.

Fortunately, there are options strategies that really are market-neutral. The calendar ...