Many clownish option mentoring firms will actually call a calendar a good way to hedge the short vega from income spreads. We here at Option Pit Option Mentoring teach our traders to better understand the movements of implied volatility across options. One important thing to understand is how volatility spikes affect volatility. The chart below is a graph of 30 day implied volatility (red) compared to 90 day implied volatility (green). What do you option traders notice:
Notice how the 30 day is much more frenetic than the 90 day volatility. I call this the vega neutralizer, yes it is true, calendars are long, what we on the floor would call, raw vega. However, traders need to remember that the movement in the front month can neutralize any movement in the back month options.
This extra movement in the front month is in many ways caused by the gamma of the spread. While the back month volatility is increasing, because of the long time to expiration, thus the price movements matter less. Meanwhile in the front month, these crazy price movements can have a more permanent effect and can really move deltas of the spread around. This can make being short of long front month options a dangerous game. Traders need to compensate for this price movement.
On the floor the only way to do this was to jack up the front month implied volatility more than in the back month. Since back month options have more time to relax, we raised the vol, not wanting market to get too out of whack. But, if one remembers how much vega is in back month options, if things get really expensive, owning those suckers can be a very dangerous game. We were always afraid to own expensive back month premium because the IV coming in could be deadly, so we didn’t raise the IV that quickly.
The same must happen on the way down, traders only have limited time to get out of a losing volatility position, or a position where the underlying has stopped moving, especially when dealing with ATM options (we have all seen why if not see the graph below).
The action of the market halting causes the whole world (retail traders included) to sell premium pretty quickly. Traders on the floor who do not want to have to choke on premium kill the IV of the front month in order to avoid gaining to much inventory of long options. With more time for back month options to take advantage of another spike in market volatility, traders are not as quick to kill the back month options. We can clearly see this happening between the graphs below, which is the way the term structure looked on 11/30:
Below is today's closing vol. Notice how December and January implied volatility was sold off far harder than Feb:
This type of understanding can help traders not only trade calendars, but double diagonals, butterflies, and condors as well. Trader's that say not to pay attention to stuff are either not trading, stupid, liars, or a combo of all three.
The AM Pit Report will be back in the morning. I want to say thank you to those in Denver for hosting me I had a wonderful time with all of you, hopefully you will take advantage of the new course we are offering, our Level 2 Prep Course. Read about it here.
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Graph from livevol