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Options Strategy: Extreme Volatility and Income

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February 12, 2015
Options Strategy: Extreme Volatility and Income

The market’s opening volley for 2015 was certainly eventful, to put it mildly, with everyone’s favorite fear gauge, the VIX, covering an unusually large swath of territory.

On at least five episodes during January, the CBOE Volatility Index, unleashed swings of six points or greater over periods ranging from three to five days. We tend to fixate on daily moves in a lot of things, but to sum it up: that’s some volatility for you.

Fear? Pshaw.

For options traders, these kinds of markets may present opportunities for shorter-term income plays. We’re now near the middle of February and markets seem to have stabilized. Nonetheless, with the Standard & Poor’s 500 Index having tested major chart support between 1,990 and 2,000 multiple times, it may be prudent to consider buying VIX calls as a hedge against a potentially deeper tumble in the broader market.

Here’s a couple different scenarios to consider:

VIX With a Fake ID?

Throughout 2014, the VIX pushed above 20 only a handful of times, but retreated within a few days in each case and averaged about 14.2 for the full year. But during January alone, we saw three moves above 20, with an intraday peak at 23.4 (see figure 1).

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FIGURE 1: VOLATILITY UPSWING. In mid-January, the CBOE Volatility Index, or VIX, jumped above 22 (yellow arrow), amid a broader slump in U.S. stocks. For the month, the VIX averaged 19.1, up nearly 35% from its average for all of 2014. Source: TD Ameritrade’s Trade Architect® platform. For illustrative purposes only.

Each of these moves lasted less than a week, which means anyone seeking income opportunities would have had to move quickly. Volatility is what’s known as a “means-reverting” phenomenon, which is a fancy way of saying it goes back to where it normally hangs out. For the VIX in recent years, that’s usually below 20.

Option traders keep their eyes open for these situations and try to capitalize on jittery markets through short-term “premium-selling” strategies. They seek positions that offer a high probability of success. Still, don’t confuse high probability with a guarantee. Even though a soaring VIX may very likely return to earth, if a decline doesn’t happen before your option trade’s expiration, your position may suffer.

Know Your Current Events

What’s happening in the real world? Are we seeing signs China’s economy is cooling further, Russia causing trouble or Greece’s woes flaring up again? Those kinds of events offer a handy excuse for a U.S. market sell-off (and a subsequent VIX spike). Another slump in oil prices could have a similar effect.

This is where VIX options come into play. Long call positions linked to the VIX can gain as volatility surges amid tumbling stocks. These calls, if they increase in value, hold potential as a hedge against a stock portfolio pulled down in broader market tumbles.

Still, you may want to wait to see if the VIX drops to “normal” levels for the last few years: 13-15, if not a little lower (in morning trading February 12, the VIX was around 16.3).

The risk, of course, is buying call options only to see the VIX settle back in to its normal range, and stay there for an extended period. But if you’re applying such positions strictly as a hedge, a low VIX may mean your stock portfolio is holding up, assuming the S&P 500 and the rest of the market continues higher.

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