Greeks and Volatility

One of the more misunderstood concepts about trading are the Greeks. Many traders think that the Greeks they are looking at in a call spread, or iron butterfly, are solid as a rock. Maybe if the rock is one of one of those fake rocks from old Star Trek Episodes. The truth is, the Greeks we see on a brokerage platforms pricing model are about as stable as Charlie Sheen. The reason is that the Greeks are a modeled output based on factors that can change; they are not law like gravity or paying taxes.

Most traders know the Greeks, but they do not know the factors that go into making producing Greeks. The factors are: price of the underlying, time to expiration, strike price, cost of carry, and volatility. As these inputs change, so do the Greeks. Four out of the 5 of these factors are somewhat easy to figure out; its volatility that is the X factor in the Greeks. Here is where most retail traders get tied up. Since most brokerage platforms do not have ‘sticky implied volatilities,’ as option prices change so do the IV’s. If IV’s are changing, so are the Greeks that the Platform is producing. The next thing the trader knows he or she is losing money and has a risk profile that is completely unexpected to the trader.

Most traders assume that when the market rises, implied volatilities fall. There are times where this isn’t the case, yet the trader can be completely fooled by their assumptions and even market indicators like the VIX (the index does have a tendency – read down on a rally – even if IV’s are incrementally up). Here is an example of how a trader can get tied up:

On April 21st, with the VIX hitting a low below 15 (14.71), a trader thinks the rally in the SPX might be a bit overdone. Expecting a market selloff, with the SPX trading 1335, a trader sells the May 1370-1375 Call spread collecting .90. The trader thinks to himself: “even if the market has a slow rally, IV’s and time decay should be on my side.”

 The Greeks read the trade as short 3.7 deltas, short .03 gamma, long 2.7 theta, short 12 vega.

Over the next 7 days SPX rallies to 1360, as the trader expects the VIX is also reading lower, although only incrementally (about .10 of a point). The trader assumes based on his Greeks that he will have:

Lost 93 dollars from delta (-3.7*25), lost 10 dollars from gamma (1/2*.03*25^2), made 19.00 from theta, made 1.00 from vega. This equates to a net loss of 82.00 per spread. However, unbeknownst to the trader, IV has been rising on his position the entire time he was in the trade.

On April 28th, the trader is actually losing 150.00 per spread, what happened? While the trader was watching VIX and his ‘theta’ the ‘strike volatility’ was slowly creeping up higher. On April 21st, the IV of the May 1370 calls was 10.46%. On April 28th, with the VIX LOWER, the IV of the May 1370 calls was 11.56.

This increase in strike vol causes a barrage of things to happen. The effect IV has on an OTM call delta can be profound, the delta increases to over -4 per spread. Plus the increase in implied volatility causes Vega to move in our face, and cancels any theta we might have received over that time period. 

That is how the trader ends up losing 150.00 on a trade that the trader ‘modeled’ would lose less than 100.00. The lesson, it is not enough to look viscerally at volatility. You have to open up the hood of the car. Good traders do not just put the key in the car engine and begin trading; they know how to take apart the entire vehicle all the way down to the cam shaft (I made a bet with my assistant that I couldn’t sneak a car part into the blog today, HA HA I win).

To learn more about IV movement check out my blog also, don’t miss Russell Rhoads from The Options Institute and I talking the VIX this Saturday at The CBOE. After the presentation I’ll take any attendees across the street to cactus for Mint Juleps.

Mark Sebastian