As you probably know, iron condors are short Vega - which represents your position’s sensitivity to shifts in implied volatility. In a relatively low volatility environment, this can be troublesome when suddenly volatility spikes and your iron condors suffer as a result. So let’s say you add some Vega to your portfolio by buying some 4 month calendars (ex: June/October) to hedge against an expected volatility pop. You now have a net Vega position of 100, your Delta is flat and you have some good Theta. The next day, the VIX spikes up 2 points on some heavy selling. In theory, you should get close to 200 bucks from the pop since you have 100 Vega and volatility went up 2 points. To your surprise your portfolio suffers just as if you had never even added the calendars - in fact it seems they made it worse. So what gives? Why didn’t your long Vega give you a lift with the VIX?

The First Dimension

There are several reasons for this. The simplest explanation is that the VIX only measures short term volatility but the Vega you own is longer term volatility, which shifts much more slowly. The more complicated explanation has to do with a 2-Dimensional volatility skew. Volatility skews are a product of order flow or how the market trades options in general. One dimension of the skew results from the market generally selling front month options and buying longer dated options. Subsequently, front month option prices become depressed relative to longer dated options, due to the constant selling pressure on them and a steady bid in long dated options.

The graphic to the right shows implied volatility in the SPY options. It clearly shows front month options having lower volatility than longer dated options illustrated by the vertical distance between the different colored lines. Because longer dated options have more volatility priced into them, volatility in these options does not need to rally with the VIX - it’s been baked into the cake already. It will take more time for order flow to push up volatility on options dated further out. Longer term traders need more time for signals to trigger. The MACD or stochastic on a weekly chart is going to be giving different signals than the daily. This delay in signal also results in the delayed order flow. It takes a long sustained move in volatility to capture Vega in longer dated options.

Stay tuned for part two, where we will discuss why even shorter term calendars might not work as much as you would hope. This is explained by the second dimension of the volatility skew. In addition, we will touch briefly on Put-Call Parity.