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Options Strategy: Planning For Panics and Volatility Spikes

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December 30, 2014

How quickly we forget. It was just a couple months ago that the sky was falling—or so we thought—amid headlines noting “gut-wrenching” drops of 2% at the opening bell, while the CBOE Volatility Index (VIX) jumped above 20, then 30 (see figure 1). 

In truth, for traders, this was a typical pullback in a stock market where many passive investors believe the only direction is up. This was just the VIX cracking 30 to notch a three-year high, in a market that fell about 10% in the preceding four or five weeks. In a world where the VIX at 10 to 12 is viewed as the “new normal,” you just might be justified in considering a 10% market drop in a month to be somewhat alarming.

Why is that scary? Because a market that drops 10% has to go up more than 10% just to get back to the same dollar-value it had before. In fact, the U.S. market has just kept going since the October washout. In the six weeks from the October lows, the Standard & Poor’s 500 index (SPX) surged about 14% (as of December 19, the S&P 500 was up almost 12% for the year).

So if a market that rises that quickly doesn’t scare, don’t let the 10% pullbacks scare you, either. Same goes for VIX above 25 or 30. Use those not-so-gut-wrenching moments as potential opportunities to make thoughtful changes to your portfolio. 

FIGURE 1: FOR "FEAR," QUITE A YEAR.

During 2014, the CBOE VIX fell as low as 10.28 on July 3 (yellow arrow) and rose as high as 31.06 on October 15 (blue arrow). On December 19, the VIX was around 16. Source: TD Ameritrade's Trade Architect®. For illustrative purposes only.

Consider the following when the market gets rattled and volatility spikes:

  • If you've protected your portfolio with put options, cash them in. 
    If you still want to own puts in case of additional volatility, consider buying cheaper ones that are further out-of-the-money. These periods of market uncertainty and high volatility can be used to potentially lock in at least some of the profits from your options. But keep in mind that this strategy provides only temporary protection from a decline in the price of the corresponding stock.  Should the long put position expire worthless, the entire cost of the put position would be lost.

  • Use the profits from those put options to add to your stock holdings. 
    While you're cashing in those put options that have just paid off, why not consider putting that money to work by buying more stock? If the market snaps back, you might be glad you did.

  • Sell cash-secured put options to potentially profit if the VIX retreats.
    Or, sell put option spreads. When volatility jumps, it usually doesn't stay up there forever. Selling put options, or put vertical spreads—that plummet in value when the panic subsides—can be an effective way to help keep a cool head when the market panics. 

Falling markets aren't necessarily a bad thing, so long as you remain a nimble option trader. Remember, you can't trade the dips if you're the one panicking, too. Since cooler heads typically prevail while everyone else is losing theirs, you might want to think about which strategies are designed to profit when the chips are down.