Calendars and Condors: Allocation and the Volatility Factor

We often refer to the complementary nature of iron condors and calendar spreads, in that the former benefit from falling implied volatility, while the latter generally get a boost from rising IV. So does that mean you should balance out volatility risk by allocating as much capital to calendars each month as you do to iron condors? Unfortunately, it isn’t that simple.

First, it’s important to think about where implied volatility might be headed, especially when it’s at one extreme or the other. If IV is very high compared to its historical range we want to scale back on positive-vega positions like calendar spreads. In months when volatility is near its historical lows, we can be more aggressive with long-vega trades.

Another important consideration is overall portfolio vega. An at-the-money calendar spread can easily have more than twice as much positive vega as an equal-size (in dollar terms) delta-neutral iron condor on the same underlying has negative vega; therefore, a 50-50 allocation would reflect a substantial bias toward rising IV. So we rarely, if ever, allocate more to the long-vega portion of our income portfolio than to the short-vega portion, even when volatility is relatively low.

Iron Condor Volatility Change at ExpirationThe third thing to be aware of is how volatility changes affect each strategy at expiration. Once we’ve sold an iron condor, any change in the value of the position that results from rising or falling implied volatility is temporary–the expiration profit curve is not affected by IV. In practice, we close our iron condors before expiration, and volatility changes can still be significant if the underlying is trading near a short strike; but the effects are negligible if we’re far enough out of the money (figure, above left) .

Calendar Spread Near Expiration, with Volatility StepsCalendar spreads, on the other hand, behave in exactly the opposite way. All along the profit curve, vega gradually increases with time, right into front-month expiration (figure, right). That’s great if IV goes up, but can be quite damaging if it falls. Although we’re often able to take our 15% to 20% target profit on calendar spreads well ahead of expiration, sound risk management suggests being, in general, a little more conservative with the amount of our portfolio we allocate to calendar spreads compared to condors.

Some food for thought as we enter our time window for opening December trades (both iron condors and calendar spreads).

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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