The U.S. Labor Day holiday celebrates American workers as well as their social and economic achievements. In a few days, market makers, professional traders, and other workers in the options industry will get a well-earned long weekend to gather their thoughts after the volatile two weeks in the second half of August. It’s a welcome relief, but a sense of uncertainty lingers as summertime comes to an end. And it leaves traders tip-toeing through a high-wire act that some will embrace and others could certainly live without.
The options industry set some records this month. The Chicago Board Options Exchange (CBOE) reported that Friday, August 21, was the busiest day ever for the exchange. Eleven million contracts changed hands, which topped the previous one-day record set four years ago when 10.9 million puts and calls traded on August 8, 2011.
The CBOE is the oldest, and still one of the largest, of a dozen options exchanges. Overall volume across all exchanges on August 21, which incidentally was a monthly expiration, was 40.2 million and the second highest behind August 8, 2011.
Market volatility measures reached extremes the following Monday. The CBOE Volatility Index (VIX), which tracks the expected volatility priced into S&P 500 Index (SPX) options, hit a high of 53.29 on August 24—rising to its best levels since the global financial crisis. Some other barometers rallied to their highest levels ever. VXEEM, a gauge for the emerging markets, hit a new all-time high of 111.39, while VXFXI, which tracks volatility in China’s equities market, moved into uncharted territory as well.
|Aug. 24 Intraday High
||Year to Date
|S&P 500 Volatility
|NASDAQ 100 Volatility
|Russell Small-Cap Volatility
|Emerging Markets Volatility
|Euro Currency Volatility
The extreme pessimism reflected in the volatility indexes, as well as the options volume surge from Friday, August 21 to Monday, August 24, subsided in the days that followed. After a volatile trading session Tuesday, the S&P 500 rebounded Wednesday through Thursday and erased the entire loss from the prior two days. Anxiety levels subsided, and most measures of market volatility fell sharply from their peak levels. For example, the VIX dropped 55% from the intraday highs on Monday through Thursday, August 27. (The table above shows the sharp decline in volatility indexes from their peak levels.)
In the mid-20s, VIX is elevated relative to its 2015 range and is up 36% year to date. Meanwhile, average options volume across the exchanges through late August was roughly 20.5 million, which represents 33% greater volume than August 2014, when 15.5 million contracts traded on a typical day.
In other words, pessimism is no longer at the extremes seen from August 21 to 24, but judging by the higher options volumes and the elevated levels in some of the volatility indexes, a sense of uncertainty still permeates the equities market. That anxiety is stemming from an uncertain global economic outlook as well as conflicting messages from the Federal Reserve about the timing of potential rate hikes. For that reason, tomorrow’s jobs data and reports on retail sales, inflation, and manufacturing will likely have a significant market impact heading into the Federal Open Market Committee (FOMC) rate announcement on September 17.
Tom White’s RED Option Strategy of the Week
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Market opinions, analyst expectations, and news-driven events can all affect the price of an underlying stock or index. Anyone who’s caught a whiff of this revived option volatility is well aware. One strategy that some traders believe can take advantage of this scenario is the vertical spread—specifically, short vertical spreads that receive a credit upon initiation.
A short vertical’s higher option premium typically allows for higher probabilities of success, higher credit received (which aims to reduce the overall risk), and a wider range of picks away from the current share price of the underlying instrument.
Although long verticals are risk-defined and can be a useful way to take a directional stance, short verticals are intended to give you a cushion and better probabilities of success due to the distance away from the current share price. Time decay, or theta, also works in your favor as the price of your short vertical loses value each day into expiration.
In fact, verticals are the most basic option spread. The thrust behind verticals is hedging one option with another: when one makes money, the other loses money. You also reduce your risk on the directional position, which is a great way to get your feet wet when trading options.
The idea is that in exchange for relatively low risk, you give up the possibility of massive gains. But don't fret: verticals (either a bullish vertical or bearish vertical) are popular with investors because of the limited nature of their risk, and profit potential that, although limited, can still amount to many times the risk taken (you’ll have to factor in transaction costs, too).
In many stocks, option volatility and margin requirements are so high so as to prohibit either buying or selling options outright, whereas verticals typically do not incur such obstacles. Verticals can offer investors an efficient way of creating long or short exposure in a stock.
A little baseball analogy may help: A vertical spread allows you to hit singles, doubles, or even take a walk when taking a directional stance on a trade. Swinging for the fences can be an expensive way to trade.
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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