Several recent Options 101 articles have demonstrated that butterfly and iron condor option trades can be hurt by expanding volatility. These trades are negative-vega trades. Vega measures how much a trade's profit-and-loss (PnL) will be helped or hurt by a change in implied volatility in the options involved.

Implied volatility can be roughly equated to the spot volatility. It can be higher or lower than the typical historic volatility of the underlying. It's a component of options pricing.

When we're looking at individual options, implied volatility works on extrinsic value, expanding or contracting that extrinsic value. If a call option is $5.00 in the money but costs $7.00, it has $2.00 in extrinsic value. The rest of its value is intrinsic because it's in the money by that much. If the underlying abruptly falls by $3.00 in price, the intrinsic value of that call will decline to $2.00 ($5.00 - the $3.00 loss in price of the underlying). However, implied volatility may rise on the sharp drop. Because the implied volatility is rising and working on the extrinsic value, that extrinsic value not shrink as much as would be expected and may even rise, depending on the reason that the underlying abruptly dropped lower. While it's unlikely that the rise in implied volatility will plump up the extrinsic value enough to make up for the $3.00 loss in intrinsic value, it could cushion the loss. I heard that in the 1987 crash, the implied volatilities jumped so fast that even some call options were more valuable as the underlying's price dropped precipitously, but I haven't been able to verify that anecdote.

The more extrinsic value an option has, the more the option's price is impacted by changes in implied volatility. What happens in a complex position composed of several different options? The resulting vega can be positive or negative, depending on the strategy. When the overall vega is positive, PnL is generally helped by an expansion in implied volatilities. When vega is negative, PnL is generally hurt by an expansion in implied volatilities. Of course, the strategy's PnL will also be impacted by price movement.

We know that the familiar butterflies and iron condors are typically negative-vega trades. What if a trader feels that the implied volatilities are at a low point when compared to historic volatilities, theorizing that there's a risk of the implied volatilities rising? Is there a complex trade that takes advantage of rising implied volatilities?

Yes and no. Time spreads, as they are sometimes called, can be positive-vega trades. Examples are calendars and diagonals. Let's look at the more familiar calendars.

Imagine that about midday on January 21, with the SPX at 1,839.08 and the VIX (the SPX's volatility index) at 12.97, a trader thought it was likely that the VIX would soon rise. Although the VIX isn't always an exact proxy for the implied volatilities of specific SPX options, it's a good benchmark for our purposes for this speculation. The VIX (and implied volatilities in SPX options) is considered low when it's in the 11-13 range.

Let's set up a theoretical at-the-money (ATM) SPX calendar by selling 4 1840 FEB14 puts and buying 4 MAR14 puts on that January 21 date.

FEB14/MAR14 1840 ATM Put Calendars:

A note: This is just one example of a calendar. The calendar could have been built by using calls instead of puts, and the trader could have decided to buy APR14 calls instead of MAR14 ones. In fact, some experienced calendar traders might buy those APR14 1840 options and then, when the FEB14 1840's had dropped enough in value to meet that trader's parameters, bought back the FEB14 1840's and sold new MAR14 1840's against the APR14 1840's from the original calendar. Let's consider the one-month trade using the pictured FEB14/MAR14 combination, however.

We see the typical tent shape for a calendar. This tent, however, is slightly different than the tent shape for a butterfly. Notice the way the expiration graph curves down when it approaches the maximum $5,000 loss? When you see curves like that on an expiration graph, you know that there are options from two different expirations composing that position.

The pull-down tab shows us that this is a positive-vega trade. Vega at the beginning of this trade is 324.23. Delta is a low 2.47. That means that this trade should actually benefit from a drop lower, because the vega is so much bigger than the delta, right? An expansion in volatilities by 1 percent (for example, a rise from 14 percent to 15 percent) should benefit this trade by $324.23 while the price drop that brought about that small rise in implied volatility shouldn't take away that much in value.

That's true, over a small price change. But we remember what's coming soon to this trade, don't we, thinking back to January's market movements?

Same Trade, about Midday on Friday, January 24:

Since this theoretical trade was opened on January 21, the SPX has dropped from the original 1,839.08 to 1,805.06, 34.02 points, and the position's PnL has suffered, perhaps more than that trader thought it might. That's a lot of points. Moreover, delta has grown more positive as the SPX has dropped, so each point lower hurts the PnL more than the point before it. (The negative gamma tells us this will happen.) IV for the composite FEB14 series has risen from 10.36 percent to 12.99 percent, and for the composite MAR14 series, from 11.45 percent to 13.11 percent.

Let's dial down a bit. The composite IV's for the FEB14 series have risen 12.99 percent - 10.36 percent = 2.63 percentage points, but those for the MAR14 series have risen only 1.66 percentage points. It's painting in broad strokes to say that the sharper rise in implied volatilities in the sold options have plumped up the sold options' prices more than the bought long options were plumped up by a lower rise in implied volatility, but that's the basic idea. In other words, market participants must have deemed that the move would likely be over long before March expiration, and they didn't send implied volatilities up as much in the MAR14 series. Therefore, those MAR14 long puts didn't perform as well as a hedge as they would have done if both series had gained the same percentage points in implied volatilities. That hurt the PnL for the trade.

Mostly, however, the huge price drop took its toll. Butterflies are still subject to the effects of adverse price movement if that price movement is big enough.

Of course, a trader would have a plan for adjusting calendars before entering a calendar trade. This article wasn't intended to suggest that the trader would just stare at the screen and allow a trade to drop to a 13.39 percent loss on the margin without having a plan in effect. That plan might have been to move some or all of the calendars to a new ATM when the SPX price approached the expiration breakeven or when the trade reached a certain percentage loss. The plan might have been to move some of the sold strikes lower as the SPX moved lower. I'm not a calendar trader, so I'm not making suggestions for this specific trade. These are some of the tactics sometimes taken, but a trader should test adjustment tactics and have a plan in place that meets that trader's outlook before considering calendars.

Instead of offering adjustment suggestions, something I could not do with authenticity, this article is intended to suggest that calendars will suffer from a huge price adverse move even when implied volatilities are rising just as butterflies will suffer from a huge adverse move even when implied volatilities are dropping. The positive vega probably helps cushion the loss, but whether it does and how much it does depends on the market outlook for the month of the long options, too. They may not work as well as a hedge as they were expected to work if the drop in price is believed to be a short-term drop, so that the implied volatilities in the hedging further-out long strike don't rise much.

Would-be calendar traders must have adjustment plans in place. More importantly, if a huge move is expected, it may not be a great time to put on any complex trade other than a pure directional trade, even if the volatility move would seem to favor the trade.

Linda Piazza