Condor Options

Financial markets change along with the real economies on which they depend. This maxim applies to investing strategies and options markets, too. For example, the “fire and forget” approach to option selling that some traders favored in the pre-crisis world is no longer tenable (if it ever was). Risk appetites have shifted, order flow is moving into different products, and the cast of influential market agents is composed of different actors. As detailed in the attached video, here are some ways that options markets have changed, possibly for good, since the financial crisis.

Post-crisis changes in options and volatility from Condor Options on Vimeo.

1) High implied volatility skew: the shape of the skew curve seems to have shifted to a permanently higher level since the financial crisis. We looked at historical IV skew in some detail earlier this year, and trading activity this spring and summer has confirmed the same basic conclusion. Whether because of increased desire for equity hedges or for some other reason, the average implied volatility of SPX puts relative to calls has never fallen back to prelapsarian levels.

2) Widespread acceptance of volatility products: the daily volume of CBOE Volatility Index (VIX) futures and options and of the related volatility exchange-traded products (ETPs) has been doubling every year since 2009. Asset managers and retail investors are using volatility products to hedge against market declines and to speculate on risk scenarios. Of course, hedging is not a new concept; what is significant is that the orders that might have gone to index products like SPX puts or even to individual stock hedges is also flowing now to volatility-linked ETPs. There is as much investor confusion as ever about the purpose of products like iPath S&P 500 VIX Short Term Futures ETN (VXX), and some investors have probably spent the last few years over-hedged. Dynamic portfolio hedges using volatility products offer a much better overall return.

3) Volatility risk premium gets jittery: while there is a dull roar of skeptical hedgers constantly buying protection, there also seems to be a certain efficiency with which traders will arbitrage away any excessive option premium that creeps in during the run-up to a major event. This claim is harder to verify empirically, but there is a definite sense that flat-footed option sellers who abjure tactical changes are more likely to get caught out as markets adjust more quickly to events. For instance, it was a common practice among some groups of traders in years past to trade short volatility spreads like iron condors in a constant, systematic fashion – without market inputs. That was never the most profitable approach, but it is also now a riskier one. Markets can swing quickly from newfound appreciation for risk as threats emerge (fiscal cliffs, the Grexit, central bank action) to relative complacency, and it is more important than ever to be nimble when sentiment shifts.