Macro Wrap – Summer’s Lease Hath All Too Short a Date

by Enis August 13, 2013 8:26 am • Commentary

We received a question last week that I wanted to revisit today, because it’s of heightened importance in a quiet market like the one we’ve experienced in the past month.

Hi,
Many of the trades executed are Flies. Are there distinct advantages to this structure? It seems that it is like threading a needle – have to get close to the short strike, it has to be close to expiration, and its difficult to adjust. In addition it has twice as many contracts to execute as plain spread. Just curious as to the advantages.

Kristen responded:

CC wrote a bit about our use of butterflies in this post from March: http://www.riskreversal.com/2013/03/08/considering-our-options-what-structures-are-working-in-this-market/. You’ve probably already taken a look at the Butterfly part of our education section as well. Although Flies do give a limited profit area as opposed to a long call spread or put spread which give you profit anywhere above or below them respectively, Flies give the trader a few different ways to make money. Many of the Flies we do are short gamma and straddle an expected move. They therefore take advantage of decay in the options given that the stock does what it’s expected to do. This gives a bit more probability on your side. You can center this sort of fly to be directional but still have the potential to make money if stock doesn’t move all the way you thought it would and you can take advantage of vol crushes after events.

CC’s entire post from March is a worthwhile read, but this was his key conclusion:

So what this means is until the market’s trend changes and volatility spikes for more than a few days at a time, the best defense is to be either short gamma outright in the form of defined risk range trades (ITM flies are great for this) or if wanting to get long volatility at such low levels, selling near term gamma as a defense against killer decay in the form of calendars.

This is obviously a strategy that works until it doesn’t. What would change is if the market hit turbulence for any sustained period of time at which point the actual volatility could be much higher than what options are pricing. In that case long gamma is the preferred structure. But until that happens it’s best to be on defense as far as decay goes.

Current market realized volatility is at its lowest level since March of this year.  Not surprisingly, short-gamma strategies like in-the-money butterflies or calendar spreads have worked much better than long-gamma strategies like at-the-money put spreads or call spreads.  The current spread between 10 day realized volatility and 30 day implied volatility in the S&P 500 index is near the highest it has been in 2013:

10 day realized vol (white) vs. 30 day implied vol (red) in SPY, Courtesy of LiveVolPro
10 day realized vol (white) vs. 30 day implied vol (red) in SPY, Courtesy of LiveVolPro

With this backdrop, long premium strategies have generally performed poorly.  As long as the summer doldrums continue, we’d be careful about short-term options strategies that are exposed to much decay.