As he mentions in the lecture, the sources for these sorts of ideas are not who you might expect.

For instance, here’s the ratio of SPY 3 month implied volatility to one year implied volatility since 2012:

The only two occasions when we got close to backwardation here were in May 2012 and the end of December 2012 (fiscal cliff). In 2013, the mean level has been about 0.83, which just means that 3 month SPY options were typically about 83% as expensive, in IV terms, as one year SPY options. We’re intentionally using further dated options to filter out some noise of the sort that you would get with e.g. a VIX study.

There were three occasions that got the 3m1y term structure to perk up this year, but it’s the most recent jog higher that has my attention. Instead of spiking higher, the term structure rose steadily from mid-May until it peaked around 0.90 on June 5th.

Keep in mind that this flattening of the term structure – presumably on talk of reduced Fed asset purchases? – required a decline of less than 70 S&P 500 points. The chart below zooms in on this period with SPY prices for comparison. This behavior seems consistent with the nervous fidgeting I described in late April.

After the big rally on June 7, the market has already made up half the distance to its recent closing high. Option implied volatility, though, has further to fall. If stock prices continue to stabilize and the 3m1y estimate returns to its recent floor, a time spread opened for a debit (short 3 month, long 1 year) should perform well. Given the preference these days for unrelenting marches higher, I wouldn’t care to be short upside gamma too close to the money, so a double calendar or double diagonal makes more sense.

To come to grips with the problem, Merkel and Schäuble are willing to abandon ironclad tenets of their current bailout philosophy. In the future, they intend to provide direct assistance to select crisis-ridden countries instead of waiting for other countries to join in or for the European Commission to take the lead. To do so, they are even willing to send more money from Germany to the troubled regions and incorporate new guarantees into the federal budget. ‘We want to show that we’re not just the world’s best savers,’ says a Schäuble confidant.

French and German ministers are also set to unveil a “new deal” on Tuesday designed to address the widespread problem of youth unemployment. The plan would use funds from the European Investment Bank to help small and medium businesses hire workers and to encourage apprenticeships.

Let’s get a snapshot of Euro STOXX 50 volatility to inform our trading. First, notice that the one month implied volatility of both SX5E and SPX options is ranked at about 6% versus the last five years. The headlines this year have been all about U.S. equities making new highs, but the volatility bid on eurozone equity indexes has been falling as well.

SX5E & SPX 1-Mth IV %-ile rank (5Y). Source: STOXX, CBOE, Condor Options

The following chart shows the slope of SX5E option implied vol at ten and two month horizons, i.e. how expensive it is to roll a long volatility position. A high (low) value indicates a contangoed (backwardated) term structure. The low of 0.80 in August 2011 corresponds to the period with the worst outlook for eurozone unity; the highest levels here came in late 2012, before weakening data and the Cyprus saga unnerved some people.

VSTOXX 10-Mth / 2-Mth Slope. Source: STOXX, Condor Options

The term structure on this estimate is only slightly above the median value since 2010. If these new fiscal policies boost demand in southern Europe, we could see VSTOXX contango push to new highs.

• Nemo’s Bond Crash Course – One of my resolutions for 2013 was to understand fixed income better. His recent bitcoin explainer reminded me of this bond intro. Also: @groditi, David Schawel
• Goldman: AUD/USD has plenty more downside – I’ve been buying straddles and puts here and there since late last year (viz. early = wrong). The recent breakdown in AUD has been validating and it looks like foreign direct investment is moderating.
• Hendry’s Eclectica are long Japan – “Back in 2008, we purchased a ten year 40,000 Nikkei one-touch call option.” Huh.
• Stealing from the internet – it’s about how to scrape web data into R.
• JGBs: “Yes I would, Kent” – no reason to worry quite yet about Japan. Simpsons clip is just right.
• Pair trading index options
• Nobody is committing to Jumbo SPY options quite yet – maybe we have enough S&P 500 products for now?
• There is zero correlation between the Fed printing and the money supply. Deal with it. – Very good.
• And finally, some hard-core metaphysics by me: Material Composition and Theory Choice and the tl;dr version.

On May 6, 1994 Robert Francis Goldthwait made his mark on television history.  Better known as Bobcat Goldthwait, he chose for some strange reason to set fire to the interview chair during a guest appearance on the Tonight Show.  This incident lasted only 30 seconds or so as Jay Leno used his beverage to douse the flames.  I think what Bobcat was trying to do, in his own unique way, was to demonstrate that volatility spikes are often doused very quickly in the financial markets.  I commend him for this bold lesson in not panicking when volatility hits the stock market. [CBOE Options Hub]

The lesson is that when, from time to time, some crazy incident spooks the market, there are usually adults around – in the form of cash-rich value investors, central banks, or other agents – to calm things down. As a Letterman/Conan fan, I draw an additional lesson from the analogy, which is that even subpar market actors can get the job done, provided they have the right tools.

And finally, this scene from the Larry Sanders show teaches us that volatility comes in clusters.

The Condor Options newsletter

The purpose of the strategy is to profit from the volatility risk premia that are priced into options. While the volatility risk premium is a consistently observable, ongoing feature of option markets, the strategy does not adopt an agnostic, “always on” approach. Instead, we select trades in markets where the expected risk-adjusted premium is the greatest.

One of the most frequently asked questions we receive is how to manage positions that are under pressure or are unprofitable, and there have always been vendors and others selling tips on how to “adjust” losing iron condor positions; one unique feature of our strategy is that it does not depend on overwrought, complex adjustment techniques, relying instead on straightforward delta and gamma updates and the intuitive idea of spreading risk across a book of trades. Real-time and historical results speak to the effectiveness of our approach.

Performance data for the Condor Options newsletter is updated at the Performance page, including a trade sheet and monthly return data.

Our average hold time for each position has been about 35 days, and our delta hedging trades are updated weekly but only when needed – so this isn’t a strategy that requires constant attention or active management. We are accepting new clients at this time.

@condoroptions My interpretation is more benign. I think that the market is just pricing lower average volatility long term.

— Eli Mintz (@VixCentral) April 30, 2013

Here’s why this is a plausible explanation of those recent flattening periods in the VX slope. If the market is expecting lower volatility over the long term, that should make VIX futures prices at longer horizons more “sticky” during short term volatility spikes. So if SPX declines 3% or so but lower long-term vol expectations are in place, we would see some movement at the front end of the VIX curve but not as much on the back end, and that would entail some flattening in the term structure even if the short-term vol reaction wasn’t extreme.

That’s a persuasive idea and it would make sense if it were true. How much weight should we give the notion of lower vol expectations? This chart shows the daily changes in VX June futures over the last few years – excluding April, May, and June since the futures become much more volatile closer to expiration. Over the last few months, the June 2013 contract has been acting normally: less volatile perhaps than the June 2012 contract was, but the same or more volatile than the 2010 and 2011 contracts. The mean value of the most recent series is lower than in previous years, which is also consistent with the idea of a gradually lower price for medium term volatility.

At the same time, there’s still something to the idea that markets have been more reactive lately in the short part of the curve. Look at the ten day standard deviation of the daily VIX close:

The most recent spike was the highest we’ve seen since the August 2011 European debt crisis. And you can clearly see the three spikes in this series corresponding to the flattening term structure that inspired my earlier post. Another way to characterize this is that the realized volatility of implied volatility is higher than it has been in some time.

Since December 2012, however, changes in the slope of the VIX term structure have been more violent than in years past. The attached chart shows the log ratio of the maximum and minimum VIX futures values on each day (blue) along with the S&P 500 over the same period (black). Since we haven’t seen many periods of sustained VIX backwardation in recent years, it’s safe to read the Y axis such that high values indicate a normal contangoed market and low values show a flattening term structure (i.e. market stress).

Prior years have been characterized by rough but discernible trends. However, since the fiscal cliff situation captured the attention of investors in late 2012, there have been three occasions in which this slope estimate swung from 0.40 to 0.15 or lower. Again, those sharp declines indicate a flattening term structure, with short-term implied volatility rising faster than longer-dated option premium.

The speed of those declines and snap-back resolution shows a market that is quicker to react negatively than we’ve seen in recent years, even with asset prices at multi-year highs. Before December, the sharpest flattening in the term structure was in May, when the market saw a drawdown of more than 9%; the most recent bear flattening needed a market decline of just 3.8%. Investors could probably stand to relax a little. At the very least, this indicator shows the very opposite of complacency.

Fig. 1. S&P 500 Index, March 6 – April 18. Source: CBOE

Now, trading strategies can be classified according to the source of their risks/returns, meaning that we can sort strategies into the buckets known as option greeks. For example, a buy and hold investor is long deltas; a mean reversion strategy is short gamma. What sort of risk exposure worked well recently?

1. Owning deltas means profiting from a directional move in the underlying. Owning deltas, whether positive or negative, was not a winner over this period. The market made a round trip back to 1,540.

2. Owning gamma (by buying calls or puts, or both) means profiting from convexity. It’s analogous to a trend-following strategy in which you commit more capital as momentum builds. That didn’t work well, either: the carrying costs in early March were recovered on the trip to 1590, but then given up (and then some) when the market reversed.

3. Theta is the cost of owning that convexity. Being long theta / short gamma worked in March and we’ll come back to this.

4. Owning vega means profiting when implied volatility in an option rises. This is where a lot of people will put up a chart of VIX and say: see, implied volatility exploded, VIX moved from 13 to 18! But that ignores the roll down costs associated with a real product. Instead, look at how May VIX futures traded over this period: they fell from 16.50 to 14, and then rallied back above 17. That means being long vega saw a drawdown during the period more than twice the size of the eventual gain. If you closed out a long May VIX position on Friday, you did so profitably but only after some rough trading.

Fig. 2. May VIX futures, March 6 – April 18. Source: CFE

The best strategy over this period was to be short gamma / long theta. The best way to adopt that sort of exposure is by trading iron condors. There are other ways to be short gamma – like selling straddles or strangles naked – but that’s a riskier and more difficult approach; a condor is essentially a short strangle covered by a long strangle. March and April were a perfect demonstration of how gamma-oriented trades can augment portfolios consisting of other strategies and investments. If the market makes a round trip, price-wise, you won’t make anything by owning shares, and if implied volatility is flat or higher, short volatility trades will struggle to pay their way. But no matter what else happens, time still passes, and in this sort of market, it pays to be on the right side of time.

Fig. 1. CVIX – Major FX 3M IV. Source: Deutsche Bank

The May GLD strangle I recommended earlier this year paid off well, although to be honest I wasn’t expecting anything quite this dramatic. Active traders should actually favor the short vol side here. Look at the spike in one month GLD implied volatility (GVZ) as of Friday:

Fig 1. GLD and GVZ, 2012-2013. Source: CBOE, Condor Options

At pixel time, GVZ has vaulted up again, near 32. There’s no word yet on changes to COMEX margin requirements, although it’s safe to assume those changes are coming. You can monitor those requirements here. To the usual reasons for favoring short volatility positions after a spike, add the fact that higher margin requirements at the exchange are a forced reduction in leverage and hence in volatility.

My favorite trade in this situation would be a short straddle on medium term GVZ options, with a strike price of 20 or so. The volatility of GLD implied volatility is incredibly high, and unlikely to remain this high, so as vol-of-vol declines, profits are likely to accrue more quickly than usual to sellers; the downside strike incorporates the view that GVZ is just as likely to mean revert once GLD calms down as VIX does after an equity selloff. GVZ options aren’t active enough yet and the market is too wide, at least on the screen, but GVZ futures have been seeing steady activity and we’ve started a short (and admittedly early) position there. Selling cash-secured puts in GLD will also be an attractive trade once the metal finds a short-term bottom.