How can you tame the effects of volatility on time-decay options plays in this high-volatility market? This post explains the dangers of “volatility skew” to time-decay strategies like calendars.

In my last post I tackled a very interesting question from TradeKing client Pauly B; he wanted to know if and how he should systematically reduce his position vega on strategies like condors and calendars, which tend to perform best in low-volatility environments.

(Vega is the Greek measuring the theoretical effect of volatility swings on your options position. Volatility tilt and volatility skew are two related concepts that often catch new options traders unawares.  Check out the “Read on…” section below to get up-to-speed on this and other terms that may be unfamiliar to you.)

In today’s post I wanted to address the second part of his question, which deals with a concept known as “volatility skew”. Pauly B writes: “Some of the skews allow for  ‘deflation of the vega balloon’. When trading a skew where you have some wiggle room for vega deflation (i.e. front month has higher volatility than the back month), is there a minimum skew number you look for prior to putting on your calendar spread?  I would also assume you would want a stable underlying without wild and wacky price movements.”

You answered your own question there, Pauly B – thanks for doing my work for me! Just as you noted, when I trade calendars “I want a stable underlying” -- to me that means avoiding volatility skew or tilt wherever I can. I would suggest aiming your skew to be within a few points either way from front- (Jan) to back- (Feb) month. If the skew is larger than 10 vol points (front-month higher), it implies to me that there is some news or event I need to be aware of.

As a rule-of-thumb, I would try to avoid making a calendar trade into a volatility trade. If the skew is large the trade really becomes more about volatility than time. Why choose a time-decay play in this instance instead of, say, a butterfly? This is a slightly unconventional take from most folks who trade calendars, but this is what has worked best in my experience.

Regarding time periods, I usually wouldn’t go longer than three months out with your calendar; it’s not optimal to be in a calendar during earnings season, which can be a bumpy time, volatility-wise. My one trick is to make my long month (back-month) the month that earnings are to be announced and then partake in the volatility rise as earnings approaches, making sure I get out before the actual date.

Read on…

TradeKing offers plenty of great educational material on topics mentioned in this post. Take a look at the following:

Vega is the Greek measuring the theoretical effect of volatility changes on your options position. In my three-part blog series, I define vega, talk about the usual characteristics that can lead to options with large vega, and explore the importance of watching vega for your total position.

More recently I blogged on position vega and calendars – that’s a good companion read to this post.

What’s volatility skew? Find your answers in my posts on volatility tilt and volatility skew, two related concepts, here. While you’re at it, read up on their cousin, volatility crunch. All these phenomena are common ways volatility changes can dramatically (and aversely) affect your options position.

What’s a calendar or condor? Head over to The Options Playbook under Education – look for Plays #27 and 28, Long Calendar Spread (w/ Calls) and Long Calendar Spread (w/ Puts) respectively. You’ll find Long Condor Spreads, another time-decay strategy, under Plays #24 (w/ Calls) and #25 (w/ Puts).

To learn more about how calendars can be a useful play during low-volatility periods like the post-earnings season, check out Dan Sheridan’s All-Stars post Trade the post-earnings snooze with calendars.

If you’re more of a visual learner, go to Education > Resources > Videos and check out the Calendar Spreads (Long) educational video. You might also find the Volatility and Probability webinars there useful.

Thanks for the great questions, Pauly B!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

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