Sure, the S&P 500 (SPX) hasn’t made much headway in the past seven months and, just last week, was sitting unchanged year to date. But the aimless meanderings of the broader market and its volatility measures may be masking some noteworthy sizzle—and sometimes fizzle—across specific sectors and other financial markets.
The energy sector, for one, has experienced a few bumps in 2015 and is down some 12% year to date. Investors may be worried that profit growth in the sector could stall as crude oil prices spill to six-year lows. Gold has lost its shine in recent months as well, with five-year lows in the yellow metal weighing on the basic materials group; it’s down 6.4% in 2015.
The news isn’t all bearish, clearly. Sectors including consumer discretionary, health care, and technology are sporting respectable year-to-date gains. Consequently, the broader market clings to a 1.5% gain for 2015.
Anxiety levels are bit elevated in August, however, as fears about China’s currency policy have added to recent worries about the global economic backdrop. This tipped SPX just into negative territory for August and pushed the CBOE Volatility Index (VIX) off its late-July lows of less than 12 to a recent reading near 14.
While VIX is ticking up from the lower end of this year’s range, activity across emerging markets (read: China) is even more impressive. As evidence, VXEEM, which is the volatility measure for the MSCI Emerging Markets Index, is ascending to the mid-20s and is more than 12 points greater than VIX (figure 1).
Tom White’s RED Option Strategy of the Week
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
So what options strategies might make sense in a relatively low-volatility environment? Last week, our tip introduced low-volatility calendar spreads and focused on a long calendar spread as one way to make your own noise in a quiet market.
Now let’s talk about short calendar spreads. A short call or put calendar spread is simply the reverse of the long calendar spread: long front series and short deferred series. The big difference (and it’s a biggie): short calendars are not as risk-defined as their long calendar cousins are. In short calendar spreads, the long option in the position expires before the short one, which could result in you holding an uncovered short call or put. Keep this in mind, because such a position does present significant or potentially unlimited risks and may require you to make necessary adjustments.
Calendar spreads, whether they are calls or puts, maximize their value when the stock price is at or near the options' strike and the front-month option is expiring. Calendar spreads have their minimum value when the stock is very far away from the options' strike price. If you buy a long calendar spread, you want the stock price to be near the strike price at front-month expiration. If you sell a short calendar spread, you want the stock price to be as far away as possible from the strike price at the front-month expiration.
With a short calendar spread position, the maximum loss would occur should the underlying stock remain steady. If at the first expiration the stock price is at the strike price of the expiring option, that option would likely expire worthless while the longer-term option would retain much of its time premium. In that situation, the loss would be the cost of buying back the longer-term option (the short option) less the premium received when the position was initiated (plus any transaction costs). But, if the near-term option (the long option) expires worthless and the investor takes no action, the short option becomes naked. If the resulting position is an uncovered call, the risk of loss is potentially unlimited since there is no limit to the price increase of the underlying security. If the resulting position is an uncovered put, there is a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. And the stock price could fall all the way to zero.
With multiple-month-wide calendar spreads, you may have the opportunity to adjust, or roll, your near-term options, sometimes involving a short and long combination.
This is simply an introduction. By design, although with risks you should regard, calendar spreads are one approach to a range-bound market, low volatility, and time decay.
Rolling strategies, spreads 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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