So got this question yesterday.
Correct me if I’m wrong, but the lack of volatility (ie. low VIX) has the greatest effect on the longest of options, yes?So, in truth, we should be getting drunk and buying LEAPs here, no?
My answer is yes and no. On the LEAP part I mean, lol, I drink about the equivalent of a 6 pack per calendar year.
He is correct in that a LEAP will react more to any identical move in volatility than a shorter term option. Take the SPY for example, a June ATM option now has about a .18 vega, meaning that for every one point move in volatility, the option price will move 18 cents. A Jan09 LEAP however has about a .43 vega, or 43 cents for a 1 point move.
But here’s the catch; volatility in LEAPS does not move nearly as much as near term options.
This chart shows normalized 30 day volatility in SPY, essentially what the VIX tries to capture. It has had about an 11 pt. drop, peak to trough, in the past 7 weeks. The chart here is for normalized 6 month options (as long as ivol. let’s me go) and the move there was more like 6.5 points peak to trough.
So net/net LEAP-ish options have indeed done worse in the volatility crunch than nearer ones, although keep in mind the nearer one’s decay faster. Throw it all together and it’s probably close to a wash.
But we’re not here to talk about the past. What about going forward?
Well, believe it or not that move down in the longer option is way more extreme imho than the clipping in the nearer one’s. Longer duration options rarely move this swiftly. Now of course they likely got overpriced in the March panic, but still……
The shorter the duration on an option, the more you are betting on actual stock volatility and the less on how the volatility of the option behaves. The longer the duration, the reverse. So if you feel stocks themselves are about to get volatile, near terms are better. If you just feel options got too cheap, you want to own LEAPS and the like.
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LEAPS suck, on all counts.
P.S. I’ll be sending flowers shortly for SIRF.
Regards,
Option Addict
LEAPS are rough, no question. A specialist book on the AMEX literally went under on a LEAP vol. crush in 2001.
Why do LEAPs suck? In low volatility environments, (like, prior to the summer of 2007) they are excellent stand-ins for going long the underlying stock, with leverage.
And you mitigate your exposure by selling the nearer term calls agains them. No?
that’s the key though, it’s a bet on where option vol. goes. If you time it well, sure, it’s a great move.
Trust me though, an ill-timed LEAP position is a nightmare. They literally just get repriced overnight.