Most novice option traders fail to understand fully how volatility can impact the price of options and how volatility is best captured and turned into profit. As most beginner traders are buyers of options, they miss out on the chance to profit from declines of high volatility, which can be done by constructing a neutral position delta. This article looks at a delta-neutral approach to trading options that can produce profits from a decline in implied volatility (IV) even without any movement of the underlying. (For more on this strategy, check out Options Trading Strategies: Understanding Position Delta.)

TUTORIAL: Option Volatility

Shorting Vega
The position-delta approach presented here is one that gets short vega when IV is high. Shorting vega with a high IV, gives a neutral-position delta strategy the possibility to profit from a decline in IV, which can occur quickly from extremes levels. Of course, if volatility rises even higher, the position will lose money. As a rule, it is therefore best to establish short vega delta-neutral positions when implied volatility is at levels that are in the 90th percentile ranking (based on six years of past history of implied volatility). This rule will not guarantee a prevention against loses, but it does provide a statistical edge when trading since IV will eventually revert to its historical mean even though it might go higher first. (Find out all you need to know about IV and percentiles in The ABCs Of Option Volatility.)

The strategy presented below is similar to a reverse calendar spread (a diagonal reverse calendar spread) but has a neutral delta established by first neutralizing gamma and then adjusting the position to delta neutral. Remember, though, any significant moves in the underlying will alter the neutrality beyond the ranges specified below (see figure 1). With that said, this approach allows a much greater range of prices of the underlying between which there is an approximate neutrality vis-à-vis delta, which permits the trader to wait for a potential profit from an eventual drop in IV. (See An Option Strategy for Trading Market to learn how the reverse calendar spread is a good way to capture high levels of implied volatility and turn it into profit.)

S&P Reverse Diagonal Calendar Spread
Let's take a look at an example to illustrate our point. Below is the profit/loss function for this strategy. With the Jun S&P 500 futures at 875, we will sell four Sept 875 calls, and buy four Jun 950 calls. The way we choose the strikes is as follows: we sell the at-the-money for the distant-month options and buy a higher strike of the nearer month options that have a matching gamma. In this case, the gamma is near identical for both strikes. We use a four-lot because the position delta for each spread is approximately negative delta, -0.25, which sums to -1.0 if we do it four times.

With a negative position delta (-1.0), we will now buy a June futures to neutralize this position delta, leaving a near-perfect neutral gamma and neutral delta. The following profit/loss chart was created using OptionVue 5 Options Analysis Software to illustrate this strategy.

Figure 1: Position-delta neutral. The T+27 profit/loss plot is highlighted in red. This example excludes commissions and fees, which can vary from broker to broker. This chart was created using OptionVue.

As you can see from figure 1 above, the T+27 dashed line (the lower plot left of the vertical price marker) is nearly a perfect hedge all the way down to 825 and anywhere on the upside (indicated by the upper plot right of the vertical price marker), which is seen sloping slightly higher as the price moves up to the 949-50 range. The underlying is indicated with the vertical marker at 875. Be aware, however, that this neutrality will change as time passes beyond one month into the trade, and this can be seen in the other dash plots and along the solid profit/loss line (which shows at-expiration gains and losses).

Waiting for the Collapse
The intention here is to stay neutral for a month and then look for a collapse in volatility, at which point the trade could be closed. A time frame should be designated, which in this case is 27 days, in order to have a "bail" plan. You can always re-establish a position again with new strikes and months should volatility remain high. The upside here has a slight positive delta bias to it and the downside just the reverse. Now let's look at what happens with a fall in volatility.

At the time of this trade, implied volatility on S&P 500 futures options was at its 90th-percentile rank, so we have a very high level of volatility to sell. What happens if we experience a drop in implied volatility from the historical average? This case would translate into a fall of 10 percentage points in implied volatility, which we can simulate.

Figure 2: Profit from a drop of 10 percentage points of implied volatility. This example excludes commissions and fees, which can vary from broker to broker. This chart was created using OptionVue

The Profit
In figure 2 above, the lower plot is the T+27 plot from figure 1, which shows near-delta neutrality over a wide range of prices for the underlying. But look at what happens with our drop in implied volatility from a six-year historical average. At any price of the underlying we have a significant profit in a wide price range, approximately between $6,000 and $15,000 if we are between the prices of 825 and 950. Actually, if the chart were larger, it would show a profit all the way down to below 750 and a profit potential anywhere on the upside within the T+27 time frame!

The net-margin requirements to establish this trade would be about $7,500 and would not change too much as long as position delta remains near neutrality and volatility does not continue to rise. If implied volatility does continue to rise, it is possible to suffer losses, so it is always good to have a bail plan, a dollar loss amount, or a predetermined limited number of days to remain in the trade. (For related reading, check out 9 Tricks Of The Successful Trader.)

Bottom Line
This advanced strategy for capturing high implied volatility S&P futures options by means of constructing a reverse diagonal calendar spread can be applied to any market if the same conditions can be found. The trade wins from a drop in volatility even without movement of the underlying; however, there is upside profit potential should the underlying rally. But with theta working against you, the passage of time will result in gradual losses if all other things remain the same -remember to employ dollar-loss management or time stop with this strategy. (Find out more about futures in our Futures Fundamentals Tutorial.)

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