As our portfolio vega and (negative) gamma grow (the latter to a decreasing degree each day, because the short strikes are spread out far to either side of the current underlying price), so does theta—the profit we accrue from decay in the value of our short positions. Let’s look deeper into that statement:
- Calendar-spread vega (change in net value with respect to implied volatility) increases with time, accelerating into front-month expiration.
- Short-gamma positions—ones that lose value at an increasing rate with every dollar the underlying price moves away from the short strike(s) (which includes virtually every market-neutral premium-selling strategy)—become more risky as expiration approaches; unless,…
- Short options positions far from the current underlying price add gamma.
- Time decay (theta) near short strikes also increases over time, becoming greatest in the final days before expiration.
All this is challenging for new (and even not so new) options traders to get their heads around, but most of the above ideas are visible in our current risk-profile graph:
The concave downward shape of our P/L curve at today’s close (white line) shows negative gamma. The fact that the projected P/L at November expiration (in red) is nearly flat between 119 and 132 indicates that this negative gamma is moving toward zero. The greater difference between the white line and the red line near strikes where our short positions are concentrated reflects the faster time-decay at those underlying prices.
The one key factor not evident is vega, which is positive and increasing. That means our potential profit at expiration grows as implied volatility rises and shrinks as it falls—with one big caveat: volatility skew across expiration regimes (the volatility “term structure”) can make it challenging to realize the benefits of positive vega.
There’s something skewy here…
The figure below (click to enlarge) shows implied volatility for SPY calls (left) and puts (right) expiring in November (yellow), December (white) and January (green), at a range of strikes. It isn’t unusual for front-month IV to be higher than back-month right before expiration, but the current risk-on/risk-off environment has greatly exaggerated the skew in options premium towards shorter-term options. Normally, the December curve would be below January, reflecting the greater perception of risk in selling options farther out in time.
What this “forward skew” means for us is that, while the red line in the risk profile above might look like a pretty good outcome considering the day-to-day volatility we’ve had to ride out this month, getting there might not be be that easy. As long as there’s any time left in far out-of-the-money November options, the market is paying a premium—and so will we if we want to close our short positions before the bell on Friday afternoon.
Now that we understand what we’re facing this week, let’s take account of where we stand heading into today’s session. As of yesterday’s close, our portfolio was showing a net unrealized loss of about 1.3% on total capital at risk, which translates to about a –0.8% unrealized Model Portfolio return. Our delta bias, as a proportion of capital at risk, was approximately +1.1%, and vega was about 0.6%—still pretty close to where we want to be. The complexity of our positions and how we got here, combined with expiration-week cross-currents, makes it hard to quantify exact risk-management thresholds, but we’ll definitely be watching closely if SPY is trading anywhere near about $121.75 or $130.25.