We’re reducing our upside risk to adjust for this afternoon’s rally by rolling our position in the Feb/Mar 125 put calendar up to a call calendar at the 135 strike, with the following order:
Day limit order
Buy to close 2 SPY Feb 125 puts
Sell to close 2 SPY Mar 125 puts
Buy to open 2 SPY Mar 135 calls
Sell to open 2 SPY Feb 135 calls
for a net debit of $0.08 or better.
Note that the 2 contracts specified for each leg above represent the number of contracts currently allocated to each leg of Feb/Mar DC#1.
Analysis: The vast majority of Calendar Options members have been around long enough to know what “vol crush” looks like, and those who haven’t…well, now you know. But even to a trader who understands why and how calendar positions are affected by changes in implied volatility, the dramatic swing in our unrealized return on capital at risk from +3.8% on Friday to about –5.8% this afternoon might seem like some kind of evil voodoo—after all, the index of average volatility we use in the Portfolio Analysis table has hardly budged for February and March SPY options, and the VIX, too, ended the day about where it closed Friday.
To comprehend how the picture today could be so different from the one we saw in the last Weekly Update, one has to understand that there’s no one, single implied volatility for the options on any given underlying—or even for the options expiring in the same month. Implied volatility consists of a three-dimensional surface made up of the IV of individual contracts (z-axis) across the range of available strike prices (x-axis) and expiration dates (y-axis).
I don’t have the tools to quickly and easily show tonight what that surface looks like and how it has changed shape over the past three trading days, but the bottom line is that we can’t afford to add to our volatility risk at this stage…which is why we’re making an adjustment to an existing position rather than adding a new one. Even our technique of hedging with a (vega-negative) butterfly isn’t looking like a very good alternative with the volatility “smile curve” stacked against OTM February call butterflies right now.
So what we’re doing with this adjustment trade is offsetting the negative delta of our current aggregate position, plus a little more, without increasing vega or risking additional capital. Portfolio vega, in proportion to total capital at risk, actually goes down slightly, even as we’re increasing net theta (from about 0.4%/day to about 0.6%). But, as usual, there’s a trade-off, and again as usual, it’s in the form of gamma. The increase in negative gamma is small, though (from 1.4% to about 1.9%), and is actually a natural consequence of moving the center of our P/L curve, where gamma is most negative, back in line with the current underlying price.
Even after being weighed down as much as it has, our risk profile still shows a good chance of ending the cycle with a Model Portfolio return in our target monthly average range of 3–5 percent with no additional trades—and we still have half our capital available for adjustments, hedges and perhaps another position (volatility landscape permitting). In the near-term, though, we’re keeping an eye on our new projected risk-management price thresholds around SPY $130 and $134.40.