The implied volatility surface can truly hold a bit of investor sentiment that not many pay a lot of attention to. In the last few months, we have witnessed a collapse in the VIX which many view as an indication of investor optimism. For myself, it only implies that option traders are not expecting much to happen in the short-term, specifically within the next month. In fact, this predicted market lull holds out for a few months – with March at-the-money options trading at less than 17% and 3 month at about 18%. This compares to recent historical lows in the area of about 14%. With how the markets behaved in 2008, 2009, the summer of 2010, the summer of 2011 and with so many unknowns on the global economic horizon, I really believe 17% might be the new 14%.

The interesting fact is how steep this term structure of implied volatility is. If we compare the 2 year implied volatility to the 3 month implied volatility, we can see that the implied volatility term structure spread is trading at its upper range:

What does this mean for you? It could be viewed as a signal for investor sentiment – that the near term might be calm while option traders are still expecting significant volatility in the future. It also means that short-term option hedges are a lot cheaper than longer term option hedges. This can be played by purchasing options in the near months and subsidizing these options by selling options in distant months.

In my own opinion, options purchased at a 16-17% implied volatility seem cheap when we look at the dislocations that seem to happen on a regular basis.

>options purchased at a 16-17% implied volatility

Sorry, basic newbie question here. Please explain what is a percentage of what? Option price divided by strike? Or?

This means that the implied volatility of the option purchased is between 16-17%. Generally using Black Schole’s option pricing model you can enter a traded option price and back out the implied volatility that generates that price. 16-17% would mean that the S&P 500 is trading at an annualized volatility or standard deviation of 16-17%

Hello SurlyTrader

I’v been lurking your blog recently and on several occasions you wrote about long Gamma short Vega.

With a 7% to 9% skew I totally agree with this approach.

Counting on your experience trading this trade.

My Question is:

By initiating this trade, are you keeping ratios ?

Such as long/short Gamma, Vega, IV and so..

Thanks

B.

Brad – this is definitely a good risk management question. If you are long gamma then you need to keep an eye on two things – your positive dollar gamma and the theta of your long position. If you have a theta of negative $100 per day, then you need to believe that the market is going to move enough so that your positive gamma position makes you money. Your gain on gamma, when delta neutral, is 1/2*DollarGamma*PointMove^2. If this is larger than your theta then you win. You can then add in a short-long dated option and use the same metrics. The question with that trade is what kind of a vega loss you are willing to take on a mark-to-market basis.

SurlyTrader- Thank you ,

My concern is specially the Vega component in the equation.

1. What is the proper IV(skew)ratio that will reduce the Vega risk to minimum?

2. I’s this trade better in a declining VIX (SPX uptrend) ?

Thanks again.

B.

B.