The last month of the calendar year is sometimes a bullish stretch for the stock market, history has shown. In fact, a gain during the final week is often called a “Santa Claus” rally because … well, you get it.
In 2015, however, a pivotal December 16 Federal Reserve interest rate meeting—which could produce the first rate hike in nearly a decade—could overshadow the market’s holiday focus and keep volatility somewhat elevated into year-end. The CME Group’s FedWatch Tool, calculated based on pricing in the Fed funds futures market, shows that traders are pricing in about a 70% shot for a rate hike in December according to market pricing on Friday. That’s up from the 35% odds priced in right after the Fed took a pass on an October rate change but issued a statement entertaining the thought of a December hike.
Indeed, many measures of market volatility are already ticking higher after falling sharply last month. For instance, the CBOE Volatility Index (VIX) dipped to two-month lows of 12.80 in the final few days of October before rallying beyond 17 in the second week of November (figure 1). VIX tracks the implied volatility priced into short-term options on the S&P 500 Index (SPX). It’s been labeled the “fear gauge” and is typically viewed as a forward-looking indicator of collective investor expectations.
Bond Volatility Is Rising, Too
Uncertainty about the interest rate landscape appears to be a chief reason for the uptick in risk perceptions reflected in the rising VIX. For instance, on November 4, the volatility index saw a notable 7% uptick as the S&P 500 shed a scant 8 points. That same day, the yield on the 2-year Treasury note rose to 0.84%, its highest levels since 2011. Meanwhile, the 10-year Treasury yield, which is a benchmark for mortgages and other lending, was up to multi-month highs of 2.3% in mid-November.
At the same time, anxiety levels in the bond pits seem to be creeping higher as well. The CBOE offers a “VIX” for Treasury bonds. The CBOE/CBOT 10-Year U.S. Treasury Note Volatility Index (TYVIX) tracks the expected volatility priced into options on 10-year Treasury futures. It typically moves opposite to bond prices and in the same direction as bond yields (see figure 2).
The impact of rate hikes on the equities market is obviously difficult to predict. On the one hand, tighter monetary policy signals that the Federal Reserve is confident that economy is improving and that, in turn, is generally bullish news for corporate earnings. At the same time, the higher bond yields that typically come with Fed rate hikes compete against equities for investor attraction and can weigh on dividend-payers such as utilities, REITs, and various blue chips. Plus, the stock market will begin to handicap how far and how fast the Fed might move, including weighing the risk that an over-aggressive Fed could choke growth.
As long as uncertainty remains, the stock trend is likely to be choppy and sometimes whipsaw market action as allocations shift from one asset class to another. Keeping an eye on VIX and TYVIX can help gauge whether risk perceptions are near to reaching chart-challenging levels.
RED Option's Tom White: Are Iron Condors Coming of Age Again?
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Percolating volatility expands option premiums as it raises market uncertainty. The additional option premium and uncertainty could indicate potentially attractive entry points into credit spreads. Some traders tend to focus on risk-defined option strategies such as short verticals and iron condors when volatility increases. In fact, a short iron condor is one popular option strategy that's designed to take advantage of a range-bound market or stock. Many traders would argue that an ideal time to sell an iron condor is when volatility rises and the underlying shares are anticipated to remain in a neutral or range-bound area.
This transaction involves four different contracts, or legs, around the current price of the underlying. A short iron condor is constructed by selling one call vertical spread and one put vertical spread (same expiration day) on the same underlying instrument. They are typically both out of the money and each vertical is equal width apart. There is no inherent bullish or bearish bias when selling an iron condor unless either vertical is skewed closer to the underlying instrument’s price. The amount collected on the iron condor is considered a credit for the trade. This is why high volatility provides good opportunities as option premium expands, which in turn tends to increase the amount collected.
So how can you potentially profit (minus transaction costs) on a short iron condor position? To maximize this neutral strategy, the outlook is for the underlying security to remain in a narrow trading range until expiration. When expiration arrives, if all options are out of the money, they expire worthless and you keep every penny (minus costs) you collected when selling the iron condor. Don't expect that ideal situation to occur every time, but it can potentially happen and certain market conditions may up those probabilities. Typically, a trader would prefer to close the position as close to expiration as possible for less than the amount collected. This could reduce the risk of the underlying security moving significantly ahead of expiration. Time decay (theta) works in this trade's favor as the short verticals that comprise the position lose value each day into expiration.
There are two break-even points for the iron condor position, calculated below:
- Upper Breakeven Point = Strike Price of Short Call + Net Premium Received - Transaction Costs
- Lower Breakeven Point = Strike Price of Short Put - Net Premium Received + Transaction Costs
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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