How Vega (and the VIX) Can Deceive Options Traders

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How Vega Can Deceive You
As you probably know, iron condors are short Vega - which represents your option positionís sensitivity to shifts in implied volatility. In a relatively low volatility environment, this can be troublesome when volatility suddenly spikes and your iron condors suffer as a result.

So letís assume that you add some Vega to your options portfolio by purchasing a few 4 month calendar spreads (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 2 points on some heavy broad market selling. In theory, you should get close to $200 from that pop. After all, you have 100 Vega and volatility went up 2 points.

However, to your great surprise, your portfolio suffers as though you hadn’t added the calendars. In fact, it seems that the calendars made things worse. So what gives? Why didnít your long Vega give you a lift along 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 in your portfolio is long-term volatility. The more complicated explanation has to do with a two-dimensional volatility skew.

Two-dimensional volatility skews are a product of order flow (a.k.a how the market trades options in general). One dimension of this 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. This is due to the constant selling pressure and a steady bid in long-dated options.


CLICK HERE FOR THE FULL-SIZED IMAGE

The above graphic shows the implied volatility in SPY options. It clearly reveals that the front month options have lower volatility than the longer-dated options (illustrated by the vertical distance between the different colored lines).

Because the longer-dated options have more volatility priced into them, they do not rally in lockstep with the VIX (itís been baked into the cake already). As a result, it will take more time for the order flow to raise volatility in these options.

Longer-term traders need more time for these signals to trigger. The MACD or stochastic on a weekly chart is going to give different signals than the daily. This signal delay also results in delayed order flow. It takes a long sustained move in volatility to capture Vega in longer dated options.

Continued In 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.

posted by: Condor Options

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