Understanding and properly calculating accurate volatility
levels is imperative for spread traders. In order to get
accurate volatility levels, you must first determine a base
volatility for the two options involved in the spread.

Getting a base volatility must be done because different
volatilities in different months can not, and do not, get
weighted evenly mathematically.

Since they are weighted differently, you can not simply take the
average of the two months and call that the volatility of the
spread; it is more complicated than that.

The problem is related to calculating the spreads volatility
with two options in different months. Those different months are
usually trading at different implied volatility assumptions. You
can not compare apples with oranges nor can you compare two
options with different volatility assumptions.

It is important to know how to calculate the actual and accurate
volatility of the spread because the current volatility level of
the spread is one of the best ways to determine whether the
spread is expensive or cheap in relation to the average
volatility of the stock.

There are several ways to calculate the average volatility of a
stock. There are also ways to determine the average difference
between the volatility levels for each given expiration month.
Volatility cones and volatility tilts are very useful tools that
aid in determining the mean, mode and standard deviations of a
stocks implied volatility levels and the relationship between
them.

The present volatility level of the spread can then be compared
to those average values and a determination can then be made as
to the worthiness of the spread. If you now determine that the
spread is trading at a high volatility, you can sell it. If it
is trading at a low volatility, you can buy it. But first you
must know the current trading volatility of the spread.

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.

Junes implied volatility is presently at 40 while Augusts
implied volatility is at 36. You can not calculate the spreads
volatility using these two months as they are. You must either
bring Junes implied volatility down to 36 or bring Augusts
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 options value to represent 36
volatility or use Augusts vega to increase the August options
value to represent 40 volatility. Both ways work so it doesnt
matter which way you choose.

Lets use some real numbers so that we may work through an
example together. Lets 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 $1.00.