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Which Option Expiration Cycles Are More Alike?
04/12/2010 10:52 am EST
I remember one of the very first lessons I got as a trader. The trainer, Ian, asked me “Which expiration cycles are more alike, the front month and the next month out, or the next month out and a cycle one year from now?” Much to my surprise, the answer is the later, not the former. Thus began my introduction to the term structure of options. This was a lesson that took a very long time to learn. Even when I was on a badge, I was constantly evaluating which months were most related. This month has been around a lot longer and has far more open interest, much like a LEAP, but this month is closer in time to a LEAP. So which month is most related to a LEAP? In one month, which month will be more like a LEAP?
Questions like these hound traders, who are constantly trying to figure out ways to quantify and manage a large inventory of risk. One of the answers is weighting Vega, but even that is a good guess at best. The truth is that management of term structure, understanding of how implied volatilities of the months are interrelated, can cause a trader to be perpetually stuck trading butterflies, a great, but limited trade. The time spread, be it a short-term front month calendar or a back month long-term trade, can easily be a profitable trade. The trader only needs to understand term structure. I classify the terms into three categories: The front month, the back months, and the far-out months, the most active of which are the front and back. Here is a brief look at each of the two main classifications the front month and the back month. Understanding them can take a trader’s profits into overdrive.
The Front Month
We used to say that “The front month is on its own.” This is because no term has as little to do with the other terms as the front month. When the front month begins, it initially has a moderate amount of Vega and about an equal amount of Gamma. As time passes, the Vega deteriorates more rapidly. Meanwhile, its Gamma becomes stronger and stronger. By 20 to expiration, the front month typically has little Vega remaining. This causes many novice traders to disregard the Vega of the options. This is a big mistake. This is because while the front month may have a low Vega, the Gamma factor of the option causes the front month to be hyperactive. If implied volatility increases, no month has a stronger increase in implied volatility than the front month option. In fact, if there is a customer with an axe to grind, it is possible for the front month option to increase or decrease several percentage points without the back month or the far-out month moving at all. However, if a customer comes in and wants to buy or sell the back month options, the trader can bet that the front month options will move. I liken the front month to the youngest child in the family, because if someone in the family is upset, then it is very likely that kid will be upset, even if he or she has no reason to be. What makes the youngest such a challenge is that he or she can have a temper tantrum regardless of what is going on around them.
So what strategies work best in the front month? Pretty simple: The straddle. We have all seen the chart of the last 30 days of an option’s life cycle. One common myth: That all options follow this pattern. Anyone who has read my piece on “The Card Game Effect” should know that the front month is not the efficient time to get into a condor. The trades that make the most sense, pay logical amounts, and have the most quantifiable risk are the at-the-money (ATM) options. This may be the reason why the butterfly works so well. The trader is selling the options that are decaying fast and buying the options that are decaying slower than the model (it does not matter which one) predicts. Generally, as a mentor, if a trader is pitching a 15-30 day condor, I try to steer them away from that trade because it is an inefficient use of capital.
NEXT: Understanding the Back Month Expiration Cycle|pagebreak|
The Back Month
The back month, in relative terms, has much more Vega than it does Gamma. Mind you, when I say back month, I can mean one month out, two months out, or three months out. These options are not anywhere close to expiration. However, they are not so far away that the trader can forget about their Gammas. These options are still somewhat price sensitive. If the front month is a petulant youngest child, then the back month option is the thoughtful older child. This is the older child that doesn’t get angry quickly, but when they do, look out! They are not super quick to increase in volatility or decrease in volatility. These options are steady. Generally, the implied volatilities of these options are going to be the best measure of what the expected volatility over the next 30 days will be. If a trader is trying to track the implied volatility of an option, the most accurate way to judge this is with the first term after the front month, AKA the back-month option.
The best strategies for this term are the strangle and condor. Options that have lower deltas actually decay quicker at 60 days then they do at 30 days. This is why condors work so much better when they are put on early then when they are put on at 30-45 days. By 45 days, the trader has given up over half of the condor’s quick decay. Generally, the farther away from ATM an option is, the farther in time its high rate of decay is. This is part of the reason why many successful traders don’t even trade condors. They sell strangles and then load up on units. The straddle, on the other hand, decays at a very depressed rate relative to the front-month option. This is what makes the calendar such an effective trade. This is also why it is important to pay attention to the volatility skew. Traders do not want to sell the front month when it is calm, especially when the back month is high. I’ve said it a hundred times, but maybe not like this: If a trader can’t sell the toddler when it’s in a bit of a temper tantrum, or buy the oldest child when they are in relative calm, the trader may be better off skipping the multi-term trade. To explain this in option terms, if the front-month option has an implied volatility that is a good deal lower than the back-month option, the trader should probably not enter the calendar. If the trader enters a calendar and the front month drops well below the back month, regardless of P&L, it may be more efficient to exit the trade. Heck, a short time spread may be appropriate.
This was just a brief synopsis of the term structure of options. The relationships are far more complex than how I have described it here. However, I wanted to make sure the reader understands that the relationship between the front-month options and the back months are not fixed. The youngest child is far more likely to overreact to situations than the thoughtful older child…just ask my older brother, John!
By Mark Sebastian of Option911.com
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