Ever had a nightmare so palpable that when you woke up, it took a few head shakes to separate fantasy from reality? On Wall Street, the fear of nightmare market scenarios sometimes fuels pessimism that pushes reality into fantasy, especially when it’s fueled by short-term volatility spikes. Fortunately, the reality is usually much less extreme.
Indeed, measures of broad market volatility, including the CBOE Volatility Index (VIX), are well off their August highs. VIX tracks the implied volatility priced into S&P 500 (SPX) options; trader demand for short-term volatility hedging pushes up the index, which the broader market then uses as a “fear gauge.” VIX is back in the mid-20s after a spike to a multi-year high of 53.29 on August 24.
There’s another measure worth watching: the volatility of volatility. The Chicago Board Options Exchange (CBOE) calculates the VIX of VIX, which has the ticker VVIX. This measure has dropped more dramatically than VIX itself since that August spike. VVIX surged to record highs of 221 on August 24 when Chinese economic fears and a commodities market washout sent global stocks reeling, but the daily chart shows what has happened since (figure 1).
The index has been chopping lower and, at 118.16, has trimmed nearly 100 points of the gains built in during the late-summer stock retreat. That suggests that risk perceptions are coming down. In fact, history shows that the S&P 500 typically delivers positive returns after major spikes in VVIX. December 2014 offers our most recent example. VVIX hit an extreme of 141 in mid-December that year; six months later, the S&P 500 had advanced 6% to record highs.
It’s also important not to downplay the recent volatility. The gyrations are certainly greater now than one month ago, and that’s an important reason why gauges like VIX and VVIX remain elevated. Market averages are moving faster in both directions than they were during the summer slumber. Option premiums on indexes are higher thanks to the larger daily moves. To put it in perspective, the average daily move in the S&P 500 was nearly 23 points in August; that compares to a 12.4-point average daily move in the first seven months of 2015.
In addition, uncertainty about the Federal Reserve’s monetary policy, especially with a touchy meeting looming in mid-September, is clouding stock trading. It’s gotten less clear lately whether the Fed will choose September for its first interest rate hike in nine years. This alone is a big reason to expect volatility to remain elevated through mid-September.
Still, periods of extremes are typically short-lived. Fear and panic subsides, paving the way for more orderly markets and a reality that is far less extreme than those nightmare scenarios.
Tom White’s RED Option Strategy of the Week
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
It’s called volatility for a reason! This week, I’ll skip the specific strategy for a little talk on risk-defined scenarios that may make sense in wild markets like those that jerked us from a summer slumber.
In fact, this market action is something that many traders relish. High volatility and moving markets can create opportunities in option trading. Many traders have been marking time with what has essentially been a one-directional rise in the markets for the last four years. That’s great for long stock investors and bullish portfolios, but it kills the volatility that some traders consider to be their bread and butter.
Some analysts would argue that the stock markets normalized during the first half of the year but that valuations rose too quickly as growth slowed. All good things come to an end, and stocks do not go in one direction without some healthy pullbacks. Volatility in turn increases option premium, which opens up potential higher-probability trading opportunities in risk-defined option strategies.
For instance, with a risk-defined goal in mind, some traders consider selling a vertical put spread instead of a naked put. Here’s an educational article on verticals from the Ticker Tape archives. Although the gains are capped, so is your downside risk. Or, for instance, risk-defined strategies may call for selling an iron condor rather than pursuing a strangle or straddle.
It’s clear that some traders are already kicking select strategies into action, basing their decision-making on broad market volatility. Although the VIX is not a perfect gauge for when options are “cheap” or “overpriced,” over the last few years, there has been increased options-selling volume up and down the market when VIX registers above 25, and increasing options-buying volume when VIX is below 14. Defining your risk lowers your exposure during times of major stock market swings. You can check out our website at www.redoption.com for more information on trading options in select market conditions.
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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