Crushing me to death ...

Back on 18th October 2009, I discussed why there is no Theta advantage going into a weekend or extended holiday break - this was primarily because the Market Makers adjust the implied volatility to cut the theta back so that it reflects to approximate market price when the market reopens after the break.

Market Makers cannot directly change market prices but they can alter the level of the implied volatility they plug into their option pricing models to reflect how the market would change over the space of the holiday break. By doing this they compensate themselves upfront for the theta decay that should take place over the holiday break.

Yesterday, 19th December, was expiration Friday, and we are now well under way to place our portfolio trades for January 2010, and as good traders we need to look at balancing our portfolio Vegas. So the question is should we be neutral or a little skewed to the upside or downside?

Reviewing the implied volatility and statistical volatility charts for my favourite stocks shows that both IV and SV are essentially flatlining and are in the lower 20% of their yearly IV range. This would suggest that Calendars are the way to go. However if we look at the IV to SV ratio, then almost all of these same stocks are quite over valued suggesting that selling premium via Iron Condors and Butterflies may be a better alternate strategy.

So how to choose between these strategies - what do we know about IV that will help us make the right decision?

In order to keep it simple, we know from the discussion above that Market Makers are dragging down IV to reflect the theta decay and any drop in IV will crush the life out of a Calendar and help the profitability of a Butterfly. So if we choose a Butterfly and IV in fact rises instead of dropping due to some unforeseen news event, how would this effect our trade.

Well although the Butterfly would be damaged from rising IV in the short term, the Calendar would have increased profitability from IV, the fact remains, that as we move towards expiration Friday in January 2010, the IV will continue to drop out of the trades, so the Calendar which is already at low IV may drop further and be materially damaged. However, the Butterflies fortunes should reverse as IV comes out of the trade the closer we get to expiration. Thus, the profitability of the Butterfly will improve.

Another point to keep in mind is that there is no volatility in a trade on expiration Friday, everything about the trade is know. So, I am banking on the Butterfly over the Calendar as we move through this Christmas and New Year period to have superior profitability.

Cheers