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Volatility Update: Record-Book Rewrite; Time for Iron Condors?

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August 27, 2015

An increase in investor risk perceptions is palpable. As the S&P 500 (SPX) suffered a four-day, 6.3% decline through the end of last week, trading volumes jumped to their highest levels in years and key measures of market volatility found a new place in the record book. The change in sentiment was swift and sets up an interesting backdrop heading into the historically volatile months of September and October.

Increased anxiety about China’s growth slowdown, a commodities washout, and uncertainty about the Federal Reserve’s response to it all is driving Wall Street turbulence. As evidence, the S&P 500 Implied Correlation Index (ICJ) is moving higher. The index tracks the amount of co-movement among individual S&P 500 constituents and trends higher when stocks are performing en masse. Simply put, indiscriminate waves of selling in the equities market send the correlation index higher.


How much higher? After several months of mixed and sleepy market action, the ICJ hit a 52-week low of 40.25 in early August, well below the levels in the mid-60s scored in early 2015. The index chopped around aimlessly over the next two weeks before staging a four-day, 30% spike through last Friday. 


FIGURE 1: HERD MENTALITY? The S&P 500 Implied Correlation Index (ICJ) is moving to levels not seen since early summer. The index tracks the amount of co-movement among individual S&P 500 constituents and trends higher when stocks are moving as a broad group. Data source: Standard & Poor’s. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Volatility often moves hand-in-hand with stock correlations. That was the case last week when the CBOE Volatility Index (VIX) surged to 28.03. The index closed Friday at its highest levels since October 2014; it more than doubled for the week for the biggest one-week move since historians tracked this index.

The market’s “fear gauge,” which tracks the implied volatility priced into SPX options, wasn’t alone. The NASDAQ-100 Volatility Index (VXN), the CBOE DJIA Volatility Index (VXD), and the CBOE Russell 2000 Volatility Index (RVX) also saw dramatic moves last week.

One WeekYear-to-Date
S&P 500 VolatilityVIX118%46%
NASDAQ 100 VolatilityVXN84%54%
Dow VolatilityVXD98%69%
Russell Small-Cap VolatilityRVX64%30%
Oil VolatilityOVX9%-11%
Gold VolatilityGVX19%-8%
Emerging Markets VolatilityVXEEM37%50%
Results through 8/21/15

Meanwhile, trading activity was brisk. In the options market, for instance, Friday trading activity surged to nearly 39 million contracts, according to Trade Alert data—second only to the 40.2 million contracts traded on August 8, 2011.

No Rest in Sight?

Looking forward, the panic is likely to subside, but September is sometimes a volatile month for equities markets as well.

The summer “doldrums” come to an end after the September 7 Labor Day holiday. But a heavy dose of economic data could drive whipsaw trading heading into the pivotal September 17 Federal Reserve policy meeting. Throw in Greek snap elections, developing economic stories from other parts of the globe, and triple-witching options expiration on September 18, and there seem to be ample catalysts that could keep anxiety levels—and market volatility—elevated in the weeks ahead.

Tom White’s RED Option Strategy of the Week

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

Volatility like that seen last week tends to expand option premium and raise uncertainty in the market. This can produce some additional opportunities in risk-defined option strategies such as short verticals and iron condors.

We’ve looked at long calendars, which provide one strategy in low-volatility environments. But now the tide has been changing as uncertainty ramps up.

An ideal time to sell an iron condor is when volatility rises and you expect the underlying shares to remain neutral. The iron condor involves four different contracts, or legs, around the current price of the underlying security. A short iron condor is constructed by selling one call vertical spread and one put vertical spread with the same expiration day on the same underlying instrument. They’re typically both out of the money, and each vertical is an equal distance from the underlying’s current price.

There is no inherent bullish or bearish bias when selling an iron condor unless either vertical is skewed closer to the underlying instrument’s current price. Potential profit comes from the credit collected when you sell the iron condor. This is why high volatility can provide opportunities; option premium expands, increasing the amount you can collect. Be mindful that high-volatility markets can move fast, inducing unforeseen changes.

So, how might a trader make money on a short iron condor position? To maximize this neutral strategy, the underlying security should remain in a narrow trading range until expiration. When expiration arrives, if all the options are out of the money, they expire worthless and you keep every penny (minus transaction costs) you collected. Don't expect that ideal situation to occur every time, but the potential is there.

Some traders prefer to close the position as close to expiration as possible, although preferably for less than the amount collected. This eliminates the risk that the underlying security might move significantly ahead of expiration. Time decay, also known as theta, works in your favor, as the short verticals that comprise the position lose time value each day as expiration approaches, all else being equal.

There are two breakeven points for the iron condor position. Here’s how to calculate them:

  • Upper breakeven point = Strike price of short call + Net premium received
  • Lower breakeven point = Strike price of short put – Net premium received

Find more on this strategy as well as a video example of an iron condor here.

Spreads, iron condors and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

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