Implied volatility calendar spreads and political events

June 2012 options in $SPY (and several other index options) are currently showing implied volatility levels below the longer term options, such as Sep 2012. The front month option, which only has 8 days to run at the time of writing, is trading 2 vols below the 3 month option. On the face of it, this is quite unusual for two reasons.

Firstly, implied vol for very short term options (with say a week or less to live), is more often than not higher than for back month options. This is probably because very short term options have much higher gamma than longer term options and so it could be argued there is less desire for traders to be short these options. In other words, they have higher risk in at least one sense.

Secondly, there has recently been a fair amount of panic in the markets. Major equity indices fell by around 7% over April and May 2012. Short term volatility will tend to drive up the implied volatility in the nearer term options. This is because panic typically does not last indefinitely and larger price swings mean the risk due to option gamma is higher. So this is another reason one might expect to see front month options trading above rather than below longer term options.

So what is going on? Whenever the term structure of implied volatility inverts, it is worth checking the calendar and the newspapers. One really obvious factor right now is the forthcoming Greek election. This is thought to be important with respect to whether or not Greece will stay in the Euro and/or look to re-negotiate its current aid package. Right now, there is a lot of uncertainty about both the outcome of the election and the policy that any Greek government will pursue. But what is known, is that the election will not happen before the 17th June.  This is 2 days after the June 2012 options on $SPY expire. So we have a situation where uncertainty (and therefore volatility) is expected as the result of a political event. But this event is timetabled and until it happens, it seems traders think it will have little impact on volatility.

This illustrates a general point about kinks or inversions or in any way irregular term structures. There is usually a reason! Many an option trader has been caught out by seeing near term options trading at a discount to longer term options in a scenario when volatility seems to be all but guaranteed. “I’ll buy the front month vol and sell the back month vol and wait for the market to become volatile and benefit from my net long gamma position!” But if the volatility is not going to occur until the front month options have expired, this strategy may well fail. In fact the trader may find himself long gamma (from the front month options) during the period when the market is relatively quiet (in nervous anticipation of the event), and then short gamma after the front month options roll off and at the time of the event’s occurrence. This is very common with individual equity options on companies. Listed companies will have a calendar of announcements about earnings or other matters. This can often create lumps and bumps in the volatility calendars and the astute trader will account for this in his trading.

Implied volatility calendar spreads or term structures are often used by traders as the basis for option trading strategies. There are no doubt good opportunities  but it is important to ask questions about the event risk when dealing with calendars. And of course this applies to all timed contracts, whether futures, options, swaps etc.

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