Properly Calculating Accurate Volatility Levels(3)

In order to accurately calculate volatility levels for pricing and evaluating a time spread, the key is to get both months on an equal footing.

You need to have a base volatility that you can apply to both months.


For instance, say you are looking at the June / August 70 call spread.June's implied volatility is presently at 40 while August's implied volatility is at 36.


You can not calculate the spread's volatility using these two months as they are.


You must either bring June's implied volatility down to 36 or bring August's implied volatility up to 40.


You may wonder how you can do this.Actually, you have the tools right in front of you.


Use the June vega to decrease the June option's value to represent 36 volatility or use August's vega to increase the August option's value to represent 40 volatility.


Both ways work so it doesn't matter which way you choose.


Let's use some real numbers so that we may work through an example together.


Let's say the June 70 calls are trading for $2.00 and have a .05 vega at 40 volatility. The August 70 calls are trading for $3.00 and have a .08 vega at 36 volatility.


Thus the Aug/June 70 call spread will be worth $1