Why would a long calendar spread benefit from increased volatility?
**I find this sentence to be contradicting **:In sum, a big move in the underlying market or a decrease in implied volatility will help a short calendar spread, whereas a stable market or an increase in implied volatility will help a long calendar spread. Thus, calendar spreads are sensitive to movement of the underlying but also sensitive to changes in implied volatility.
I can understand how a long calendar spread benefit from a stable market, but isn’t a stable market the opposite of increased implied volatility?
Longer-dated options have higher vega than near-term options. When volatility increases, the increase in the value of the longer-dated option will exceed the increase in the value of the near-term option => gain for the long calendar spread (sell near-term option, buy longer-dated option)
Stable market would refer to small price movements now, which likely signals that the near-term option will be out of the money (i.e. expire worthless => gain since you sell the near-term option) and the longer-dated option will drop in value (but not entirely worthless as it still has some time value left in it).
Increased implied volatility would mean that market’s expectation (in the future) is a higher volatility (so that will have more impact on the value of the longer-dated option than the near-term option).
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Thanks for your reply. Helpful. Still think it is a bad way of phrasing it in the curriculum - as a long calendar spread would prefer a stable market in the near term and a volatile market in the long term (after expiry of the nearest term option). Right?
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Yes, you can say so.
To elaborate further, when they say stable market or large price swings, it is relative to the strike price.
When the underlying price is close to the strike price (i.e. stable market), the near-term option theta is more negative than the longer-term option (i.e. the time value of the near-term option declines faster than the longer-date option) => good for long calendar spread, bad for short calendar spread
When the underlying price moves far away from the strike price (i.e. large price swings), the near-term option theta is less negative than the longer-term option (i.e. the time value of the near-term option declines slower than the longer-date option) => good for short calendar spread, bad for long calendar spread.