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Options Strategy: Escalator Still Going Up? Watch Volatility

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December 30, 2014

Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

Quite a bit of financial news recently has been focused on volatility (aka vol, in the vernacular of market types). Low vol, or the absence of it altogether, seemed justified with U.S. equity markets still near all-time highs. The demand for risk protection (hedging) has been subdued, as U.S. monetary policy and economic data supports higher equities and low vol.

As option traders go, we typically want to buy options when they are cheap (carrying low premium) and sell them when they are expensive (high premium) based on relative historical levels. Although this is the optimal scenario for option traders, we have seen over the last few years that option vol is low for a reason: low demand for options most likely means little risk of movement—especially to the downside.

The markets have become so efficient recently due to rising equity prices and little concern for any significant downside moves. Also, if you are short vol (in the options markets), you have been given time to cover recently.  

Markets historically rise like an escalator and fall like an elevator. Despite this, we have seen the “elevator” drops remain relatively shallow recently. Indeed, outside of a few short-term setbacks, the benchmark Standard & Poor’s 500 Index (SPX) has been on a steady march higher for over three years (see figure 1).

FIGURE 1: ESCALATOR CLAUSE.

After briefly slumping in mid-2011, the S&P 500 climbed for most of the past three years, reaching a record intraday high above 2,079 in early December (yellow arrow). Source TD Ameritrade’s thinkorswim® platform. For illustrative purposes only.    

The Fed Buys a Put

The Federal Reserve’s Quantitative Easing program is over, but a low interest rate environment remains. Option vol also remains at low levels, but many expect this to reverse if interest rate changes take place sooner rather than later in 2015.

Market pundits often speak of a Fed “put,” which refers to perceptions that central bank policies will remain sufficiently loose to maintain “liquidity” in the financial system and encourage moves into “riskier” assets, such as equities.

The plan worked in recent years, with the S&P 500 Index late last summer surpassing 2,000 for the first time. We’re saying good-bye to the Fed’s QE, but the European Central Bank (ECB) is expanding its stimulus, which could also help U.S. and global economies.

Happy New Year, Vol

What’s in store for vol heading into the New Year? Recent activity has shown some strength in volatility. Many are expecting vol to continue to increase in the markets but this theory was communicated at the beginning of 2014 also. One concept to follow is the length of any rise in option vol.

The Chicago Board Options Exchange Volatility Index (VIX), the so-called fear gauge, is the default reading for overall market sentiment. While not a perfect reflection, it provides a widely-followed barometer of overall supply and demand for short-term options on the S&P 500.

The duration of time that the VIX rises when stocks fall may give some clue to what to expect out of stocks in 2015. If we anticipate a falling or choppy market, we could see the VIX rise on spikes but also establish higher lows.

Relatively to recent years, the VIX had some wide swings in 2014. In early July, the VIX dropped to just above 10, the lowest in over seven years, then, in October, jumped above 31 to a three-year high. Still, spikes higher were relatively short-lived. On December 19, the gauge was around 16.

If this multi-year trend continues, I would expect equities to keep grinding higher in 2015. If we see an extended downturn in stocks and a subsequent rise in the VIX, we could be in for some additional vol. While the VIX covers the overall market, many individual stocks will trade independent of this as news or moves dictate.