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Volatility Term Structure

Many traders find options to be exciting because of the implicit leverage within the securities – buy $500 worth of options and control a potential $120,000 investment.    That is only one small aspect of option trading and it is a very limited viewpoint.  Options are truly great because they provide an infinite number of investment strategies for those willing to look.  One aspect often ignored is the term structure of volatility which is a view across option maturities.

An intriguing relationship can be found between long-dated maturities and short-dated maturities.  Despite a rapid fall of the media-friendly VIX, longer dated options have kept their lofty implied volatility levels.  If we focus just on one year and one month ATM options on the S&P 500, we can see how lofty that relationship is:

The term structure spread is historically wide

The spread between the 1 year option implied volatility and 1 month options is quite wide, but looking at the standard deviation is probably the wrong metric when looking at a risk factor with such fat tails.  A better metric might be to look at a distribution of spreads:

A wide term structure spread frequency with notable characteristics

The gap between 1 year and 1 month implied volatility can go highly negative, but on the positive end of the spectrum it seems strongly capped.  We can see that about 85% of observations occur between -3% and +5% while only 5% of daily observations ever came in at a reading of greater than a 5% gap.  This implies that our current spread of 5.5% provides an opportunity.

How to take advantage of this opportunity?  Sell a 1 year option straddle, buy a 1 month option straddle vega neutral and delta hedge the position.  A simpler method would be to go long VXX and sell VXZ or similar in VIX futures.

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5 Responses

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  1. Henry Bee says

    Great analysis!

  2. Ramon says

    Great post, but I’m struggling a little with the Long VXX / Short VXZ execution example. Just take a look at the this spread and you’ll see it’s quickly falling into the abyss – mainly due to the rollover issues bc of contango in VXX. Maybe there’s a small bounce around the corner, but personally I’d be using that to enter a short on the spread.
    . . . Happy to be corrected if my analysis is wrong!

  3. SurlyTrader says

    You are correct, it is not my preferred vehicle. I *just* closed out a short position on VXX and you will see that I have generally been positive on the opposite trade – short vxx and long vxz – http://www.surlytrader.com/vxxvxz-pairs-trade/

    The best option strategy to take advantage of this is to go long short-dated SPY/SPX options and sell the longer-dated SPY/SPX options. I threw out the VIX futures combos because they are easier to *handle*. When trading the actual S&P 500 options you need to take into consideration time decay, gamma, delta and vega…all of which can shift around. On the simple side, buying the October VIX futures at 25.5 and selling the Jan at 30.4…these can whip around quite a bit but the odds are in the traders favor that the gap will close at some point. Right now I am outright short Jan 11 and plan on holding that position after rolling out of a short Oct position. I talk a lot about pairs trades to minimize risk, but sometimes I want to take an outright directional view on levels.

  4. Kristine says

    I think you did an excellent job on you analysis but can you elaborate some more? I want to understand more the flow of trading and I think this one can enlighten me some more. Sorry but when it comes to graph I am a little bit dumb and clue less. Help me please. Thank you!

Continuing the Discussion

  1. The Difficulty in Adding Vega Exposure – Tenor | SurlyTrader linked to this post on August 7, 2012

    […] are not only ageing through their theta, but their market value is declining as it rolls down the term structure of implied volatility.  The option that you bought for one year was priced using an implied volatility of 21%, but after […]



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