The volatility crisis in global stock markets has been preceded by sharp declines in the value of shares in European and U.S. money centres’ banks. Canadian banks’ shares have fallen as well, although not to the same extent. And as volatility subsides and the economy begins to stabilize, banks should lead the recovery.

What we have here is a timing issue. One way to deal with short-term uncertainty, while taking advantage of medium-term potential, is the “calendar spread.”

A calendar spread — also known as a “time spread” — is an options strategy that takes advantage of mathematical certainties within the options-pricing formula. There are two certainties at play with this strategy: (1) the certainty that an option has no time value at expiration; and (2) the certainty that time value erodes at a faster rate the closer the option is to expiration.

The calendar spread also can be attractive in an environment in which the volatility term structure is negative — that is, the volatility being implied on longer-term options is lower than the volatility being implied on near-month options. This situation can add value to the strategy as the term structure of volatility realigns itself.

This same situation appears to be playing out in the banking sector. Questions abound as to the European banks facing stiff hurdles as the eurozone copes with sovereign debt issues among its peripheral members. U.S. “too big to fail” money-centre banks (for example, Citigroup and Bank of America Corp.) have been hit hard as questions abound about their capital base and exposure to off-book items that no one seems to be able to value.

Unfortunately, Canadian banks, while healthy, are being tainted by association. Clearly, Canadian banks have not been able to ratchet up investor enthusiasm in light of the eurozone crisis and the sharp fall-off in U.S. banks.

Let’s accept for a moment that the European Union survives, which is certainly not a foregone conclusion. However, if some patchwork solution keeps the “PIIGS” countries — Portugal, Ireland, Italy, Greece and Spain — from defaulting over the next six months, that will give the European money-centre banks time to write down their questionable sovereign debt.

Furthermore, let’s assume that at some point, American politicians will begin to make decisions on the basis of what is good for their country rather than what is good for their political future — again, not a foregone conclusion.

If all this were to happen, it could lift the pall over Canadian banks. Add to that a moderate recovery in the second half of the year, and the U.S. and Canadian banks could generate some high-octane earnings not too far down the road.

What we have, then, is a scenario in which the short term does not look great — short-term volatility is at extreme levels and higher than longer-term volatility, and the medium term could be quite positive. Taking advantage of this situation becomes a question of timing — which, for options traders, leads directly back to the calendar spread.

Let’s look at some examples using Bank of Montreal (symbol: BMO; price at time of writing: $59), Bank of Nova Scotia (BNS; $54.76) and Toronto-Dominion Bank (TD; $76.47).

With BMO, sell the September 60 calls at $1.35 and buy the October 60 calls at $1.95. The position’s net cost is 60¢ ($1.95 – $1.35 = 60¢), which is also your maximum risk.

Looking at BNS, you could sell the September 56 calls at $1.15 while simultaneously buying the October 56 calls at $1.60. The net debit is 45¢.

And, finally, with TD, look at selling the September 80 calls at $1.20 and buying the October 80 calls at $1.75, for a net debit of 55¢.

In all three examples, we are expecting the Canadian banks to trade below the strike price of the short call through September. If the stocks close below the strike price of the short calls at the September expiration, you will end up with the long November calls at a reduced cost. IE