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Volatility Update: Will Earnings Tip Toward Risk Aversion?

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September 17, 2015
Will Earnings Tip Stock Market Deeper Into Risk Aversion?

The final three-month stretch of 2015 could be a pivotal period on Wall Street, and it kicks off with a tough test buried in the next round of earnings reports. Yes, the Street has collectively downgraded profit and revenue expectations due to an oil-headlining commodities slump, a strong dollar’s crimp on multinational business, and China’s sputtering growth. But revenue remains a litmus of the global economy and of traders’ risk aversion, and so earnings season could prove to be newsy.

Take note: companies could start to warn with pre-reports and guidance between now and Alcoa’s (AA) start to the reporting season on October 8.

Certainly, the broader market is in a defensive posture, with volatility heated up even as temperatures cool. Wall Street’s Q3 decline to date stirred risk perceptions and resulted in a new trading range for the CBOE Volatility Index (VIX). VIX started 2015 near 20, but this “fear gauge” fell sharply into the spring and spent much of the first half of the year at historic lows in the 12 to 16 range. As of mid-September, VIX is down from the spike north of 50 it hit in late August, but remains somewhat elevated in the mid-20s (figure 1). Since the index tracks implied volatility in short-term S&P 500 (SPX) options, higher levels suggest that market participants expect gyrations to continue heading into October. 

VIX late August spike

FIGURE 1: NEW RANGE? The CBOE Volatility Index (VIX) is down from its spike north of 50 hit in late August, but remains somewhat elevated in the mid-20s, where it has churned for much of the past week. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Oil’s Stain

Certainly, all market sectors are in the red since the end of Q2 (and only consumer cyclicals and health care are in the black year to date), but the weakness is lopsided (see the table below).

SPX as a whole is down roughly 5% since the end of June, and the energy sector’s 15% drop has been the biggest drag. At a close second, basic materials lost 11.3%. Weakness for energy and materials typically has a lot to do with trends in the commodities markets. At $45 per barrel, for instance, crude has dropped $15 since June. Gold has lost roughly $65 to $1,110 during that time. 

Year to date
Health Care
Consumer Discretionary
Consumer Staples
S&P 500
(Through 9/10/2015)

According to Zacks Investment Research, overall profit growth for the next earnings round is expected to be down 5.5% from a year earlier, on 5.1% weaker revenues. However, excluding the expected staggering 65.3% drop for energy-sector earnings, overall results are expected to be up 1.6% year over year, on flat revenues. Therefore, the overall numbers are likely to tell a mixed tale, with some sectors clearly delivering better profit growth than others.

Tom White’s RED Option Strategy of the Week: Butterflies

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

Broad market signals haven’t yet changed with the weather—stocks have seen some massive swings and volatility remains elevated, if off the late-summer spike. This climate could prove to be an interesting period for seasoned option traders as premium has expanded in step with market uncertainty. The recent moves in underlying instruments and in volatility produce additional opportunities in trading defined-risk strategies.

But should that stop you from thinking ahead? Not usually. Anticipation of a normalizing market and a drop in volatility leads some traders to look closer at butterfly spreads. A butterfly is a risk-defined, non-directional option strategy designed typically to have a favorable risk/reward scenario in the setup. It’s a neutral option strategy combining bull and bear spreads using either all calls or all puts. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices where the strategy might profit (minus transaction costs).

How does it work? The trader sells two option contracts at the middle strike price, buys one option contract at a lower strike price, and buys one option contract at a higher strike price. The “body” of the butterfly spread is the short strikes in the position, while the “wings” are the long options on either side of the shorts.

Defined risk means you know how much you can potentially profit or lose upon initiation of the position. The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices. The maximum risk is limited to the net debit paid for the position.

Butterfly spreads achieve their maximum profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration.

While the objective is to have the underlying instrument at the butterfly’s midpoint (body), timing factors into the equation, too. The price of the butterfly can take a while to expand, and the optimal time to close or exit the trade is as close to expiration as possible. We’re talking about tricky timing and price action around the short strike in the trade. Floor traders have been known to say, “butterflies are cheap … cheap for a reason.”

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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