Market Risk 101: Quantifying the Exposure of Short-Dated Option Volatility Calendar Spreads

By Dave Zurkowski

A common strategy for option volatility traders is spreading one or more option expiration against another. Items to consider when employing this strategy include theta (time decay), gamma, vega, relative volatility levels, skew, political announcements and pending economic reports.

Like most trades, there is a perceived ‘normal market behaviour’ pattern, or expectation in the mind of the trader initiating the position. For example, there is fact-based opinion that implied option volatility rises prior to scheduled economic report and declines as soon as the data is released to the market. In the majority of these cases, the options with the least amount of days to expiration (DTE) experience the greatest volatility increase prior to the data release and the greatest volatility decline after the data release. The reason for this behaviour is that the uncertainty of the information contained in the scheduled event/announcement disappears. The options with the shortest DTE are then subject to the greatest rate of time decay, which can make them an attractive item to be ‘short’, however, this assumption is dependent on prevailing volatility levels.

As traders and risk managers evaluate these volatility calendar spreads, it important to understand what the option Greeks are saying about various positions. What appears to be an innocuous position can turn into an explosive trading profit/loss if an unexpected announcement or event disrupts conventional market behaviour.

How to Identify the Risk Prior to the Event

There are tools available to traders and risk managers that can provide insight into potential risks presented by option calendar spreads. The standard Greeks (delta, gamma, vega, theta) deliver important information about each contract involved in the trade, however, depending on the actual combined position these standard Greeks don’t tell the entire story. The concept of time weighted vega offers a ‘normalisation’ of the vega (across expirations) to help solve the hidden volatility risk in the calendar spread.

For example, imagine a position that was short 500 ‘20 delta puts’ in the one-week E-mini contract, but long 150 ‘20 delta puts’ in the one-month E-mini contract. The standard Greeks may indicate that the vega exposure of this position is relatively flat and we are collecting time decay. This could be a money-making position as we wait for the one-week option to decay toward “zero” and we use this “free money” to finance our longer dated option positions. This strategy has become very popular with the Monday/Wednesday/Friday expiration cycle available each week.

However, hiding in the weeds is the way in which implied volatility will behave in a rapidly rising volatility environment (generally caused by a falling S&P price) in the next 5 days. The increase of the implied volatility of the one-week option will likely outpace the rise of implied volatility of the one-month contract. Our standard Greek vega calculation ignores this phenomenon because it defines a ‘1-to-1’ vega relationship between expirations, and therefore understates the potential exposure. A method to identify this risk is a ‘weighted vega’ calculation that relates the vega between expiration cycles using a time formula.

In the example above, the weighted vega calculation can be normalised to a 1% volatility move in the one-month option, which will produce the relative equivalent of a 2.07% volatility move in the one-week option (√ (30 (Fixed Point)/(7 (DTE)).

This demonstrates the expected change in implied volatility is more than double for the one-week option. Therefore, in using weighted vega, we unmask the fact that our sample position is actually ‘short’ vega as opposed to ‘flat’, as initially thought. Thanks to the use of weighted vega, we know a rising volatility environment will take a much larger toll on an account value. We must now make the decision if we want to assume this risk, but at least we are aware of its existence.

Conclusion

The construction of this type of trade contributed greatly to the volatility ‘melt up’ in early February 2018. These risks could have and should have been known prior to the market event, unfortunately, the lure of ‘free money’ in collecting option decay on weekly expirations was hard to ignore for some participants, however, the speed and magnitude of the S&P price drop, combined with large short option positions in E-mini and S&P weekly options produced explosive volatility gains that has caught many traders and risk managers off guard.

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