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Volatility Update: The Storm Before the Claus?

December 10, 2015
Thin ice before Santa Claus calls

Stock and option market volatility picked up in the early days of December after a notable lull in the second half of November. Anxiety levels are ticking higher along with bond yields ahead of next week’s highly anticipated Federal Reserve meeting. It’s a gathering that many on Wall Street expect to produce the first interest rate hike in nearly a decade. That week also includes the potential added volatility of “quadruple witching”—the contract expirations of futures and futures options on top of stock and index options. 

This combo could rile markets heading into what has historically been a seasonally slow, yet strong, period for the equity market. It could play a role in determining a positive or negative finish for stocks in 2015.

The CBOE Volatility Index (VIX), the market’s “fear gauge,” has seen its fair share of ups and downs. That trend continued in early December. After falling sharply from late-August highs, VIX started climbing again in late October and recaptured the 20 level briefly in mid-November before trending lower over a couple of weeks. Then, VIX jumped 13.8% in a single session on December 3, to 18.11, as stocks sold off. VIX promptly erased that move, shedding over 18% last Friday. VIX remains in the lower end of the 2015 closing-level range of 11.82 to 40.74 (figure 1).

CBOE Volatility Index


This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” near 20 in a sudden volatility spike last week before it erased that move and more. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

VIX tracks the implied volatility priced into short-term S&P 500 Index (SPX) options and typically moves higher when the equities market moves lower. The 13.8% uptick on the third day of December, for example, happened as the SPX shed nearly 30 points and fell into negative territory year to date. The next day, when SPX jumped 42 points, VIX shed 18%.

If that sounds familiar, that’s because it is. December 3 was the 12th trading session that the S&P 500 has moved from positive gains to negative for the year. The last occurrence happened on November 12, when SPX shed 30 points and fell to 2045. The index closed 2014 at 2058.90. On average this year, it has taken the SPX 10 days to return into positive territory after falling into the red. After the November 12 drop, SPX was back in the black four days later.

S&P 500 (SPX) in negative territory


This one-year chart of the S&P 500 (SPX) reveals the broad index’s latest of many plunges into negative territory this year. Data source: Standard & Poor’s. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Is the Fed Santa’s Helper?

Whether the S&P 500 closes positive or negative for 2015 is still to be determined. More than a couple dozen trading sessions remain, and some event risk likely looms: most notably, the Fed meeting on December 16. As stocks tumbled, bond yields rose in anticipation of a possible rate hike. On December 3, the yield on the benchmark 10-year Treasury recorded its biggest one-day spike so far in 2015, jumping to 2.33% from 2.18%.

Quarterly witching expiration caps the Fed week. And of course the week after that is a holiday-abbreviated trading week in which the equities market has historically launched a seasonally strong period known as the Santa Claus rally. Note this, too: the Santa rally has been especially robust in years prior to a presidential election.

According to Jeff Hirsch of the Stock Trader’s Almanac, since 1950, the S&P 500 rose by an average of 3.2% during the month of December in the year before an election. A good chunk of those advances have happened during the final week of the year. Of course, there's no guarantee that the trend will continue this year. 

Tom White’s RED Option Strategy of the Week: Ratio Spreads for Extreme Moves

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

We previously covered vertical spreads, which are made up of a short option and a long option at different strike prices in the same expiration cycle. This is one defined-risk strategy we use when we have a bearish view (expecting the underlying to go down) or bullish view (expecting the underlying to go up).

Some option traders will argue that one of the best aspects of vertical spreads is being able to define risk. A ratio spread is very similar to a vertical spread because it’s made up of a short option and a long option at different strike prices in the same expiration cycle. However, a ratio spread amps up one side of the spread. It might look like this: sell two options and buy one option, or buy two options and sell one.

Ratio spreads consist of only puts or only calls, for a debit or credit at initiation. A commonly used ratio is two short options for every option purchased. If you sell more options than you buy, your risk will be higher, as only a portion of your short is covered by the long options.

As a strategy, selling more options in a ratio spread is a directional assumption. It collects more premium from the sale of additional naked puts or naked calls. It is a limited-profit, unlimited-risk options trading strategy used when the option trader thinks that the underlying stock will experience little volatility in the near term and/or reverse in direction.

Some option traders use the strategy when seeing extreme moves in stocks and a pop in volatility. These conditions can potentially provide good reversion or contrarian assumptions. Ideally, this strategy is typically used when either (1) the implied volatility of the option expiring in a particular cycle has recently moved sharply higher and is now beginning to decline, or (2) the trader believes for whatever reason that the underlying market will move steadily in his favor during the life of the option. This is why many experienced traders initiate this type of trade after an extreme move in the shares or when they have a hunch on direction. These traders typically look for ratio spreads that are out of the money and have a cushion to break even because of the directional nature of the trade. 

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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