Some traders added calendars to their MAR and APR butterfly and iron condor trades. Why were they doing that?

To understand, let's start with the basic construction of a calendar. A calendar is a time spread, with a near-term option sold against a further-out option at the same strike. A calendar can be a put calendar or a call calendar.

ATM OEX Put Calendar, Snapped on 3/27/2013:

Note that my articles are roughed out and the charts snapped a week or two ahead of publication. Neither prices nor market conditions are the same, so this is never a trade recommendation. Also, as a result of creating a graph with a white background, some other parameters of the trade are not as visually appealing. However, it can be determine that this calendar was created by selling an APR 700 put and buying a May 700 put when the OEX was at 702.92. This creates a typical tent shape with the sides of the tent curving down from the expiration breakeven. Whenever an expiration graph shows curves rather than straight or angled lines, you know that options from at least two different expiration periods make up that position.

What else can be determined? As constructed and shown in the "Live" line under the chart, this calendar is a negative delta position. For newbies to the Greeks of options, delta measures how much the trade will benefit or be hurt by a one-point change in the underlying. When delta is negative, the position is hurt by a one-point climb and helped by a one-point drop. This delta is nearly flat, however, so it will not be hurt or helped much by a few points in price difference.

It is a positive theta position, meaning that it will benefit from the passage of time. Theta is small at this time, but it would grow as time passed, and grow quickly as expiration neared, as long as price did not move too quickly and changing volatilities did not adversely affect the trade.

The reason that some traders were adding calendars to their butterfly and iron condor trades had to do with the vega. Vega is positive. Vega relates to the impact of changing implied volatilities. When vega is positive, the trade benefits from rising implied volatilities and is hurt by dropping volatilities. That effect when volatilities drop--a vol crush, as it is popularly called--is the reason I struggle so much with calendars. However, it's the reaction when implied volatilities rise that attract some butterfly and iron condor traders. Both those trades are negative-vega trades. Adding calendars to the butterfly or iron condor trades helps balance out that negative vega effect of the butterflies and iron condors, some traders theorize.

When do implied volatilities tend to rise? That happens to some degree when there's an important market or political development such as an upcoming FOMC announcement, but the most pronounced change comes about when markets tip over and start to the downside. Or, when North Korea threatens to nuke its perceived enemies.

Let's look at why traders might have been worried about the possibility of rising implied volatilities when first putting on MAR and APR positions. Remember that this chart is not up to date.

VIX Chart as of 3/27/13:

The area within the yellow-orange oval marks the period during which traders might have been entering MAR and APR butterflies. While the VIX did spike at one point, at many more points during that period, VIX was reaching for the lowest levels in several years. While it is always possible for the VIX to move lower, as that spike down to 11.05 proved, probabilities were beginning to lean toward the prospect that the VIX would either stabilize or bounce. While the VIX is not an exact proxy for implied volatilities in the OEX, and some would prefer looking at the "old" VIX, the VXO calculated on the OEX options, the VIX is a familiar vehicle to most traders.

Those traders adding calendars to their butterflies and iron condors were hedging against a rise in implied volatilities. Of course, if they were doing that, they might want to position the calendar a bit differently, perhaps a little below-the-money so that delta was more negative and the vega a bit more positive. That's because the calendar can be hurt by excessive downside moves, too, with the negative delta changes overwhelming the good effect due to rising volatilities.

I wasn't one of the traders adding calendars. I understand the theory and I like it intellectually, but I just don't have a consistent win record with calendars. I've been caught too often in a vol crush that seems difficult to handle. Why complicate my butterfly trades when I don't feel that I handle calendars as well as I would like?

However, I offer this possibility to those of you who might not have considered this ploy, and who might have backtested calendars or traded them live long enough to feel comfortable with them. As always backtest or trade these combo butterfly/calendar positions and keep small at first when transitioning to live trades. If you don't have backtesting capabilities, put them on your brokerage's risk or analysis graph. Run implied volatilities and price up and down, and time forward to learn how they react before you consider using them as a hedge.

I wanted to close with a note. Volatility indices have moved higher since this article was first roughed out. On Friday, April 5, they dropped heavily back to test the breakout levels. It's not clear whether they'll continue rising or stabilize or even drop. Probabilities are not as soundly on the side of the trader considering adding calendars to butterflies and iron condors, and would be employed only if the trader thought that volatilities would at least stabilize if not climb and that price movement to the downside, if it occurred, would not be too rabid.