The Second Leg Down

Chapter 5The Long and the Short of It

Our analysis in Chapter 4 suggested that the implied volatility skew tends to be mispriced in the sense that there is excess demand for moderately out-of-the-money options. But what of the term structure? We want to say something about the value embedded in near-term options compared with longer-dated ones. Here, it is more difficult to be precise. Judging from broker flows, it seems as though institutional managers favour hedges with a few months to maturity. It is uncommon to see strategies that rely upon rolling weekly options and strategies that incorporate multi-year options (outside of the interest rate markets) seem equally rare. We can start with the hypothesis that, if there is any value to be found along the term structure, it probably resides with options that have a very long or very short time to maturity. We want to avoid medium-term options. If everyone wants to buy something, it's going to be expensive.

SHORT-DATED OPTIONS

Some traders argue that you don't want to hold options that are close to expiration. The standard argument is that short-dated options have the highest time decay. Figure 5.1 calculates the time decay of ATM options on the S&P 500 as a function of time to maturity. So if you buy a fixed dollar amount of options with different maturities and nothing happens on a given day, the short-dated ones will lose the most. This is true for any delta, e.g. a fixed dollar amount of short-dated 25 delta puts decay more ...