IV is a common cause of time-spread failure for market makers. When i
in the front month rises, the volatility of the back-months sometimes does
as well. When this happens, it’s often because market makers who sold
front-month options to retail or institutional buyers buy the back-month
options to hedge their short-gamma risk. If the market maker buys enough
back-month options, he or she will accumulate positive vega. But when the
market sells the front-month volatility back to the market makers, the back
months drop, too, because market makers no longer need the back months
for a hedge.
Traders should study historical implied volatility to avoid this pitfall. As
is always the case with long vega strategies, there is a risk of a decline in
IV. Buying long-term options with implied volatility in the lower third of
the 12-month IV range helps improve the chances of success, since the
volatility being bought is historically cheap.
This can be tricky, however. If a trader looks back on a chart of IV for an
option class and sees that over the past six months it has ranged between 20
and 30 but nine months ago it spiked up to, say, 55, there must be a reason.
This solitary spike could be just an anomaly. To eliminate the noise from
volatility charts, it helps to filter the data. News stories from that time
period and historical stock charts will usually tell the story of why volatility
spiked. Often, it is a one-time event that led to the spike. Is it reasonable to
include this unique situation when trying to get a feel for the typical range
of implied volatility? Usually not. This is a judgment call that needs to be
made on a case-by-case basis. The ultimate objective of this exercise is to
determine: “Is volatility cheap or expensive?”