Some members are wondering why, if we’re long vega, our unrealized profit/loss curve hasn’t gone up with the explosion in implied volatility. The answer lies in the volatility term structure. While the past couple days’ pop in implied volatility has greatly increased the amount of premium in our long March calls, it’s affected the premium in our short February calls just as much. Since implied volatility is a function of option pricing, we can get a good idea of what’s going on by looking at a chart of the ratio of one-month to three-month implied volatility.
The VIX:VXV ratio compares the benchmark index for implied volatility of the S&P 500 one month out to its three-month equivalent. A chart of that ratio early this afternoon (below) shows just how dramatically the volatility term structure has shifted—the ratio went from about 0.83 when we bought the February/March double-calendar to almost 0.94 early this afternoon (by the close, it was up to 0.96).
To see the impact on our bottom line, let’s take a look at the risk profile for our February portfolio before this afternoon’s adjustment (below; click to enlarge). The model shows that our expected return at expiration (green line) has gone up, as indicated by the wider breakevens compared to the projected breakevens (vertical lines) when we opened the double-calendar, even though the current P/L curve has dropped.
Once time decay takes the premium out of our short options, we should be in better shape. Note, however, that options are a bit like subatomic particles—the mathematical models are just roadmaps we use to decide if and when to turn one way or another; they’re no guarantee that we’ll end up where we intended to go. But by the same token, our outcome is highly correlated with the modeled probability distribution (most of the time—outliers are a topic for another day), and the Calendar Options strategy was developed to keep the odds in our favor over the long-run.