Earnings numbers could dictate levels of market volatility on Wall Street from now until at least mid-November. That means potentially little time to slow down and catch our breath as volatility could be building on top of a wild conclusion to Q3.
Alcoa (AA) unofficially kicks off the Q3 reporting period after today’s closing bell. Johnson & Johnson (JNJ), Intel (INTC), Netflix (NFLX), and a number of big financial names release results next week. Then the pace of reports picks up notably from there. Given the uptick in investor anxiety about macro-economic trends—including China’s slowdown and below-potential U.S. hiring—the big question is whether Corporate America can deliver results that restore Wall Street’s faith in at least the domestic economy? The Street has already braced for a weaker performance, which may leave the markets susceptible to surprise.
One measure of volatility, the CBOE Volatility Index (VIX), often moves opposite of the broader market and that pattern certainly held true over the volatile past few months. The S&P 500 (SPX) suffered its worst quarter in years and the VIX moved up 34.4% from June through September. Recall that VIX, the market’s so-called “fear gauge,” tracks the implied volatility priced into short-term SPX options. It shoots higher when asset managers bid up premiums for portfolio protection.
Not Just VIX
Other measures of volatility also moved higher this summer, a potential reflection of the breadth of market uncertainty. One notable mover was a measure tracking Brazil. The CBOE Brazil ETF Volatility Index (VXEWZ) fell some 13% in Q2 to 30 then rallied to the mid-50s through late September. Brazil’s equities markets had been under fire amid concerns about the country’s mounting fiscal deficit, political instability, and unfolding political scandal.
But it wasn’t just domestic economic concerns driving Brazilian equity market volatility higher. The move was part of a larger, global trend spanning emerging markets, oil, commodities, and more (see the table below).
|Global CBOE Volatility Measures||Q1||Q2||Q3||Year to Date|
|S&P 500 Volatility
|NASDAQ 100 Volatility||VXN||-12%||11.9%||38.7%||36.6%|
|Russell Small Cap Volatility||RVX||-20.7%||11.6%||26.8%||12.2%|
|Emerging Markets Volatility||VXEEM||-14.3%||12.3%||55.6%||49.7%|
|Euro Currency Volatility||EVZ||41.8%||2.3%||-22.6%||12.3%|
|Treasury Bond Volatility||TYVIX||8%||19.4%||-19.7%||3.6%|
The point is, it may prove difficult and not too constructive to think of earnings in isolation, free of the global twists and turns that continue to spin markets in both directions. If a majority of companies deliver better-than-expected results and offer soothing words about the outlook for Q4, share prices could react favorably. On the other hand, if weak numbers add to recent jitters about macro-economic trends, overall levels of volatility in the equities market the world over are likely to remain elevated into the final months of 2015.
Tom White’s RED Option Strategy of the Week: Straddles
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Bullish and bearish news invite volatility and given the weight of news of late—China’s slowdown and Fed policy twists included—some investors may not be surprised by big moves. The problem is pinning down which way for that big move. That’s why some of the more sophisticated option traders might initiate a strategy designed to profit from such a move regardless if the underlying asset goes up or down. It’s the size of the move that matters, not the direction. Long straddles are one strategy that takes care of this assumption.
Long straddles involve buying both calls and puts on the same underlying asset. The strike price is same on the purchase of both calls and puts in the same expiration cycle and is typically done at the money. The idea is that should the underlying significantly increase or significantly decrease—such that the new value of the call or the put can be sold for more than the cost to purchase the two positions—you potentially profit (minus transaction costs).
A rise in volatility should also theoretically increase the value of a straddle. Because you’re paying for two options, buying time decay, also known as theta, on both sides, the stock usually has to move considerably to produce big profits. Initiating the strategy simply involves buying a put and call with an expiration that gives the underlying enough time to move significantly, and straddle buyers are best served by not holding their positions as expiration gets close, as that is when time decay (theta) is greatest. This also applies to strangles.
So, when is the best time to buy option straddles? They typically work best when volatility is low or steady but you anticipate a potential catalyst, like earnings news or other big announcements, on the underlying, or in the overall market.
The risk is the debit paid. But there’s more to keep in mind. If implied volatility drops, the position can also lose value, even if the underlying moves. This is the reason that buying straddles or strangles before earnings (or other news) can be a risky strategy. Even if the stock moves, the drop in implied volatility that often happens after earnings are released can more than offset the gain from the move in the underlying.
So yes, this strategy is risk-defined in nature (selling straddles is not risk-defined), which means you can’t lose more than you paid. But be aware that a significant move is needed to profit.
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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