"Not waving, drowning in IV crush ..."

Over the past year the VIX has been steadily dropping from a high around 47.50% to the current level of around 15.5%. Some would say that this is a significant drop indicating that the volatility in the market has gone away and that Calendars are probably an excellent option strategy to employ. The rationale behind this is because if IV is mean reverting, then there is an expectation that IV will begin to rise significantly as the market hits all time post CFC highs and reverses.

VIX Volatility Index as at 22nd May 2011

A glance at any of the main indexes shows that they are all at their highs and comments in the markets from fund managers and traders alike suggest that a major retracement is imminent - interestingly the commentators have been saying the pull back is imminent for months now and yet the market just keeps rising and the VIX just keeps dropping.

DOW JONES as at 22nd May 2011

So if IV is so low, how have Calendars been going over the last few months. In a word, horrible. But why is this happening. The short answer is that the VIX is really not telling us the full stroy on IV.

Intra day volatility is going through the roof on some days while on others it is quite flat. Over the past week the DOW dropped 80 points one day due to rumours around further Greek sovereign debt worries, and then jumped up 60 odd points the day after on the basis that the Bond market was not that worried. One and two standard deviation moves happening back to back are becoming an all too familiar sight on the markets these days.

Market Makers have essentially been reflecting this market indecision by concentrating more on the IV of the front month rather than the back month and thus strategies such as Calendars are finding that the gain through rising IV in the back month is just not enough to compensate you for the IV crush that happens to your short front month legs in the Calendar resulting in the trade losing money. This has been a familiar pattern over the past six months as the IV keeps dropping but intra day spikes keep the Market Makers on their toes.

So if we believe that the market is on it's highs and a material reversal is just around the corner and we want to do Calendars, how much pain can we take from IV crush once we are in a trade ?

One way that we can gauge the pain and establish a rough point for when we would have to adjust our trade is to use the following formula:

IV of long option - (Calendar Skew * 150%)

SPX ATM Calendar Skew - 22nd May 2011

 Plugging in the numbers from the option chain for an ATM $1335 Call Calendar we get :

June IV : 12.29%
July IV :  13.13%
Absolute Skew is : 0.84%

So adjusting the ATM IV of the long back months option by 150% of the skew we get :

13.13% - (0.84% x 150%) = 11.87%

The interpretation of this 11.87% is that the IV of the trade can drop from 13.13% down to 11.87% before this trade will begin to lose money. That is and IV crush of 1.26% or a negative move of around 9.6% in IV before we begin to feel the pain in this trade. Another way to look at the 11.87% is that if the IV drops and the 0.84% skew disappears, then the price of the Calendar should still be around the same price we entered the trade for. This would enable us to exit the trade near break-even.

Cheers