Trading Them There Volatility

• Posted by Adam Warner
• on August 9th, 2009

So when implied volatilty (see SPY 30 day IV in yellow up top) sits consistently above realized volatilty (see SPY 10 Day HV in blue on bottom) , makes sense to net short options, right?

Well, yes. In theory. Every day you are short an option that is overpriced relative to the volatiltiy of the underlying, you should earn more in decay than you lose on the price action. A 24 VIX for example prices in that 2/3 of the trading days will see moves of less than 1.5%. And we are indeed seeing fewer days than not with that sort of action. Hence, modestly overpriced volatiity

In practice though? It’s not so simple.

Even though the ranges in SPX are muted, they’re all in the same direction. Let’s say you’re short gamma in SPX or SPY (short straddles, strangles, or something like that) True discipline would require geting flat by the end of each day.

In other words, let’s say you’re short 500 gamma in SPY. For each point up(down) you get shorter(longer) the equivalent of 500 shares.How do you hedge that? One choice is to even up by the close. The other is to stay passive and not chase, and try to avoid the whipsaw of chasing strength and shorting weakness.

Anecdotally, I don’t really find one approach far superior over time. Much depends on your risk tolerance.

But in the Summer of 2009, one side has clearly trumped the other. Someone truly getting flat by every close would feel like he’s fighting a major uphill battle, forced to buy higher and higher every day. But while he’s had the sensation of losing every battle, he’s also likely won the war. He’s probably ahead.

Conversely, a gamma seller willing to let his positions expand a bit and only buy back into weakness (if at all) is getting slammed. That despite having the right position in theory on volatility as he’s been short it and it’s only declined.

Both these sides are generalizations of course. There’s an awful lot of gray in between the black and white I described.

What’s my point?

Well, it’s not an easy game. Options sometimes let you win when you’re wrong, but they can also let you lose when you’re right.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus