Condor Options

So last time we talked about why longer term vega might not give you a lift with the VIX. So what about trying to catch the VIX with closer volatility using a 1 month calendar spread (June/July). Once again you might find yourself slightly frustrated. So lets take a look at the second dimension of the volatility skew to see why.

The Second Dimension

The second dimension of the volatility skew comes from the fact the market likes to buy out of the money(OTM) puts for protection and sell OTM calls for income. This consistant bid for OTM puts raises their implied volatility(IV) while the selling pressure on OTM calls results in lower implied volatility. It should be noted though that because of Put-Call parity even though the puts are what are being bought heavily the respective call will have roughly the same IV, this is to avoid arbitrage opportunities. This dimension of the volatiliy skew is illustrated in the graphic to the right by the negative slant of the lines. This skew is actually part of the reason the VIX rallies when the market sells off. While the market is around 140 the VIX reflects the IV of the 140 strike options (18.5%) but if the market moves to 138 it reflects the IV of that strike (19.5%). So the VIX rallies simply becuase it is looking at lower strike options with higher IV. This would explain why your calendar might not get a lift as expected. The volatility of your actual options did not change – at least not yet.

As a final note, not all options have the same skew. We have simply talked about the skew in the SPY which reflects the skew in a lot of index options. In addition the skew has been known to look differently. For example back in the internet bubble in 1998-2000 the skew slanted the opposite direction as the market perceived upside risk as greater than downside risk. The market was selling puts and buying calls.

Wrapping it up

Having a knowledge of volatility skews can greatly help your understanding of what your risks are and how those risks are likely to impact your portfolio. Knowing that Vega can be deceiving at times can help you make better trading decisions. There are some great ways to take advantage of the skew once you have an understanding of it. Calendar oriented spreads are one of these great ways- which is part of why we are introducing Calendar Options.