Condor Options

We’re reducing our risk this afternoon by closing the call side of our December/January double-calendar, as follows :

Day limit order
Buy to close 2 SPY Dec 131 call
Sell to close 2 SPY Jan 131 call
for a net credit of $0.36 or better.

Note that the 2 contracts specified above represent all of our current position in the Dec/Jan 131 call calendar portion of the 123/131 double-calendar.

Analysis: I’m going to start off the analysis a little differently this evening, because I imagine that even experienced members are having trouble wrapping their heads around how our portfolio risk profile could have gone from nearly ideal on Friday (albeit with a smaller unrealized profit than we’d normally expect so close to expiration) to the sorry state shown in the new P/L graph near the bottom of the page, after a mere three-day sell-off that all the options-pricing models said it should have weathered just fine. The answer is our old enemy—volatility skew.

In what can only be described as a “perfect storm” of volatility skew, traders’ focus on near-term fear has ran amok this week, with implied volatility skewing against our positions in two key dimensions. The graphs below plot SPY option implied volatility for December (white lines) and January (red lines) at the 20 strike prices nearest the current share price, for both the calls (left) and the puts (right). Two things stand out: 1) December’s IV is a lot higher than January’s, and 2) the difference increases dramatically from the 121 strike down, reaching extreme proportions at our lowest short strike (113).

The long and short (literally) of all this is that our short December 113 put position reached an implied volatility of about 46%, while the long January 107 puts paired against them haven’t increased in value as expected, with IV remaining under 32%. Even more significant, the value of our other long January positions has collapsed, with IV dropping to about 20% for the calls and about 23% for the Jan 123 puts. Altogether, these shifts in implied volatility took a huge toll on our P/L profile.

We’ve worked very hard to develop a strategy that manages volatility risk and guards against “vol crush”; but it nevertheless happens that occasionally volatility skew shifts unpredictably and dramatically, and there’s nothing we can do about it except manage risk going forward, as dictated by our strategy rules. In this case, that means cutting delta exposure by half—ideally, because expiration is only two days away, by unwinding some or all of one or more positions. Selling the call side of the higher, double-calendar position reduces portfolio delta, in proportion to total capital at risk, from about 4.1% to about 2.3%.

At the same time, it slices vega from 3.9% to 2.9%, cutting our volatility risk in case January IV continues to drop. The 131 calls are so far out of the money that the calendar spread has negative theta—it is losing value over time—so we’re also eliminating that drag on portfolio value.

However, this all comes at a price. By closing what was essentially serving as our main upside hedge, we’re now stuck with more than 1% negative gamma, compared to the relatively tame prior value of 0.7%, and that negative gamma will get a lot bigger if SPY rebounds more than a dollar or so. What we need to focus on now is keeping losses contained (no more than we can expect to recover in an average month or two) and managing risk diligently so that we can stay in the game long enough to reduce our current unrealized loss.

One more not-so-pleasant note: SPY closed today’s session only about $0.50 above our new projected downside risk-management price threshold. If the market doesn’t rebound tomorrow (or if it bounces too much), we might have to open a last-minute hedge position, most likely a butterfly—or else simply limit our loss by closing the remaining positions and start looking for the next opportunity.