Editor’s note: This is the second of a two-part series on out-of-the-money options. Read part one.
When most people think of extreme conditions in the stock market, they imagine sharp sell-offs and high volatility. But those aren’t the only possible extremes. Stocks can also move sharply higher, and volatility can sink to the cellar.
The second extreme environment doesn’t seem to bother investors much. Who complains that their stocks are moving too high? But to shrug off this scenario is to skim over potential opportunities. Even when stock volatility drops to boring extremes, it can pack trading ideas for option investors. That’s because out-of-the-money (OTM) put options can offer the chance to buy relatively cheap short-term protection or allow traders to use less money to make speculative bearish trades to hedge a bullish portfolio.
As discussed in part one, OTM call options tend to have lower volatility levels, but as we’ll explore here, OTM put options tend to become more and more expensive as they move further out of the money (figure 1).
One thing to keep in mind is that the CBOE Volatility Index (VIX) spends most of its time dropping. In other words, as markets slowly climb higher after short, high-volatility periods, broad market volatility slowly drops back down to lower levels. This has a negative impact on option prices, especially puts.
The burden is on option traders to know where to look for value. And this is where trading the extremes comes in handy.
How Low is Low?
One way to determine when volatility is at extreme lows is by comparing the short-term volatility tracked by the VIX (30 days) to a longer time frame such as the CBOE S&P 500 3-Month Volatility Index (VXV), which covers 93 days. In general, volatility is higher over longer time frames because there is more opportunity for the unexpected to happen. But sometimes traders get so complacent that the VIX falls much lower than VXV—even to an extreme.
Let’s look at an example. In December, the VIX/VXV ratio dropped sharply below 0.80 (figure 2). Because of this, OTM put options were very cheap. To further illustrate our example, we'll take a look back at the options on an actively traded broad-index exchange-traded fund. The February 2015 put at the 203 strike price closed at $3.24. Its implied volatility was 13.46%. Remember, the idea is that this provides traders with a potential opportunity to buy relatively cheap short-term protection or use less money to make speculative bearish trades to hedge a bullish portfolio.
By the middle of January, as volatility traded higher and stocks oscillated in a sideways pattern, the same put contract rose in value with implied volatility at higher levels (figure 3). Not only did markets have a bearish posture during this time, but the VIX also rallied. Both conditions helped put options gain in value.
Making bearish trades is not necessarily easy. It’s tough to time trade entries based on moves that occur quickly. But knowing how you will decide when options are trading at extremes might allow you to buy OTM put options cheaply enough to make the risk worth considering. That can position you for volatility to jump back to normal levels.
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David Settle, content manager at Investools® from TD Ameritrade Holding Corp., presents Market Forecast, including step-by-step charting analysis.