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S&P 500 and Vol Term Structure

It is difficult to tell what “normal” market levels are anymore, but I can certainly say that the gap between longer term option implied volatility and short-term option implied volatility is quite elevated.  When measured as the gap between 2 year ATM implied volatility and 1 month ATM implied volatility, we can generally see that spreads above 5% have often occurred before subsequent corrections in the equity markets.  Unfortunately, we can also see that this wide spread can continue on for months at a time before there is a correction:

Regardless of our views on market direction, this spread provides interesting trading opportunities for those willing to play in options.  Since short-term options are trading at *cheaper* volatility levels than longer term options, the market is providing ripe opportunities for calendar trades – specifically where longer term options are sold and shorter term options are bought.  A delta hedged position could provide for some gamma-scalping if market volatility resumes while being short longer-term, more expensive vega.  The risk is that realized volatility remains low and the short term options decay due to a faster theta.

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6 Responses

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  1. theta says

    “The risk is that realized volatility remains low and the short term options decay due to a faster theta.”

    That’s not the biggest risk. The biggest risk is gradual decline in low volatiilty until a point where you don’t have gamma any more, and then market decline accelerates, volatility explodes, and you lose your shirt. That’s exactly what happened in all the previous occasions where the term structure inverted, most recent last summer.

  2. SurlyTrader says

    When you are delta-hedged and gamma scalping, your intent is to keep your positive gamma high. You do not care if the market declines slowly and if the gamma of your option goes down as it approaches a delta of 1, then you re-up with a high gamma option near the money. There is no such thing is a static position when scalping gamma. Yes, on a mark-to-market basis you will lose as the vega of the short position in the longer term option works against you, but you should be making money on the long gamma position if there is truly market volatility.

  3. theta says

    When you “re-up with a high gamma option near the money”, this will obviously happen at a much higher IV level, most likely even higher than the current short-term skew implies. So, if market stays here, you may or may not make enough money gamma scalping to recover your theta, and if market crashes you WILL get slaughtered.
    If you want to protect yourself on all levels of spot you will need a complete strip of options, not only the ATM. A variance swap would achieve that and would be a better trade (it would have to be rolled forward every month of course). And speaking of rollover, if and when the market crashes, which is when you will need your gamma the most, it will cost you to roll it, as the term structure will be in backwardation. There is no arbitrage here.

  4. SurlyTrader says

    The only arbitrage trades left are handled by black box algorithms at hedge funds and banks. The rest of us have to place trades that we believe create the best risk-adjusted returns.

    Only institutions have access to variance swaps in the OTC market (at least in the United States), but those are simply created exactly as you put it – though a strip of purchased options at each spot, which is impractical for the retail investor.

    You seem to have the mentality that if a trade can go badly, then it shouldn’t be executed. I believe in, and execute under, the idea that no trade should be able to “slaughter” you. Place enough correctly sized trades that are in your favor from a probability standpoint and things might just work out in the long run.

  5. theta says

    Fair point, I totally agree with your last sentence.

    To be clear, I am not saying that the trade shouldn’t be executed, I was merely describing the biggest risk it entails, which was not mentioned in the article (you mentioned that the risk is bad carry from low realized vol, and not the big losses in a possible crash). Regardless, I agree that with such steep term structure the risk/reward for this trade is attractive.

Continuing the Discussion

  1. Wednesday links: dormant ideas | Abnormal Returns linked to this post on February 8, 2012

    […] Check out the gap in implied volatilities.  (SurlyTrader) […]



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