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Short Term Volatility is Absurdly Oversold

January 13, 2012 By Steven Place

diver through the waterAs we head into options expiration, option traders are thinking about a few things:

  1. The market is rallying and realized volatility continues to head lower.
  2. Overseas and headline risk continue to drop, therefore actual risk must be getting lower.
  3. We've got a long weekend ahead of options expiration, so we need to price the long weekend in already.

Because of these reasons, near term volatility has been driven through the floor.

The $SPY at-the-money put for january currently has an implied volatility of about 12.5%.

The implied volatility for February is 17.65%.

The difference between the two is significant.

We can also compare the performance of $VIF and $VIN -- these two indexes break up the component calculation in the $VIX to far and near dated options, respectively.

This relationship is extremely stretched to the downside-- and I think near term volatility is at a floor, while further out in time may be subject to further downside.

There is a way to play this, but it's complex and many retail traders don't incorporate it into their trading playbook

It's the short calendar spread.

Because of margin issues, it's best to look at /ES futures options as you can trade on futures margin, which frees up more cash.

The trade I like?

The ES Jan/Feb 1295 Calendar sold for a credit of 18.00 or higher.

This trade makes money a few ways:

  1. If the ES sees a strong move between now and next friday.
  2. If volatility drops hard on the February contracts
  3. If volatility rises on the January contracts
  4. If the vol "spread" normalizes again.
The main two risks here are:
  1. Time decay
  2. Front month vol continues to drop hard.

This trade can be managed by "gamma scalping" which means you would trade $SPY or a similar instrument to hedge your deltas and keep the long gamma.

IWO Subscribers were given the full rundown of this trade and others like it in last night's Happy Hour, which is a weekly educational video series.

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