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Options Strategy: Last Year’s Volatility Lessons, 2015 Edition

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January 15, 2015
Options Strategy: Last Year’s Volatility Lessons, 2015 Edition

We’ve all flipped our calendars to 2015 by now (remember to stop writing “2014” on your checks, assuming you even still write checks).

Still, when it comes to options markets and volatility, the final days of last year foreshadowed a few key items to watch for the next few months: equity market volatility, oil market volatility, and volatility of volatility itself. Let’s discuss.

Equities

Remember how the Standard & Poor’s 500 Index lost 10% in less than four weeks last fall? Then, roughly five weeks later, the market got it all back, and then some? That’s what we call “opportunity,” and 2015 will likely offer similar scenarios. If and when it does, the astute option trader might play it like this.

Tanking stock markets lead to spiking volatility, as measured by the VIX. A spiking VIX may also suggest a market that’s bottoming out. When the stock market skids and the VIX surges above 20, as happened several times last year, keep your eyes open for a day when the VIX closes down from its previous settlement. That might be an opportunity to sell out-of-the-money stock index put spreads, which may generate returns once the market settles down, without saddling you with a lot of risk (in this case, your risk includes the difference between the strike prices, minus premium received, less commissions paid.)

Oil

Crude oil plunged roughly 50% over the past six months, dropping near six-year lows in early January (see figure 1). Think it’s going to stop falling? Hard to say. But if you sense a bounce in the offing, here’s another potential opportunity to consider selling out-of-the-money put spreads.

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FIGURE 1: OIL SLICK

Benchmark crude oil futures in early 2015 sank below $50 a barrel, the lowest since the 2008–09 financial crisis. Source: TD Ameritrade’s Trade Architect® platform. For illustrative purposes only.

Amid the recent swoon, implied volatility in oil prices has reached the highest levels in over three years. If oil stages any sort of rebound in 2015, related volatility gauges probably will decline substantially. This may be a chance to not only capitalize on a potential turnaround in oil prices (even if it's short-lived), but also a potential drop in options volatility. Plus, an out-of-the-money spread gives you some room to be wrong in case the bottom isn’t in yet, because time decay is working in your favor.

Volatility

The VIX spent much of 2014 in the low teens, although it usually doesn’t stay below 12 for long. So why not buy some VIX calls when the index hits that level? It may seem like inexpensive protection, but that might not actually be the case. VIX options, like all options contracts, are affected by implied volatility. When the VIX spikes, so does implied volatility, which means options become more expensive.

Be patient. After a spike, it may take a little while for options to get back to their “normal” range. If the VIX is low and VIX options volatility is below 80%, now you’re talking inexpensive options. It might be time to consider pocketing some inexpensive out-of-the-money calls or buy some out-of-the-money call spreads.

When the VIX inevitably takes a trip skyward, you might consider cashing in your options and possibly going back to selling equity index put spreads.

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