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Volatility Update: Bottom Picking is Way More Art than Science

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January 21, 2016
Volatility is making a splash, but things aren't yet as wild as August 2015 volatility readings

The S&P 500 (SPX) blew through August 2015 lows last week, testing its chart near 1850, or the lowest level since October 2014. Recall that late August—defined by China-induced jitters—proved to be an important turning point for the SPX; it rallied nearly 12% in the two months that followed. Yet, while some market watchers are once again talking about market bottoms, others see important differences between the recent lows and the ones in summer 2015.

You Call That a High VIX?

For starters, the CBOE Volatility Index (VIX) is nowhere near the extremes of late August. The index has been vacillating in the mid-20s throughout much of 2016 (figure 1), and although it moved beyond 30 late last week, the move doesn’t compare to that summer spike. The market’s so-called “fear gauge” hit multi-year highs north of 50 then. To some observers, that means that it may have more room to run. 

One-year chart of CBOE VIX

FIGURE 1: VOLATILITY BACK IN PLAY.

This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” pushing above 27 as the early-2016 stock smackdown continued last week. It remains well off the 50-plus reading hit in volatile August. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Watch Volume

What’s more, overall options volumes are not increasing as they did in August. On August 24, for example, total options volumes across all the exchanges jumped to nearly 40 million contracts, according to the Options Clearing Corp. That was the second busiest trading day for the options industry on record.

The strongest volume day so far in 2016 is the 25.7 million contracts traded on January 7. Compare the spike in August 2015 on the volume chart (figure 2). Recent trading activity is nowhere near those levels. 

Options trading volume through early 2016

FIGURE 2: QUIET COMPARED TO AUGUST?

Early 2016 options trading volume picked up, but remains well shy of the high-action trading days seen during the summer. Data source: Options Clearing Corp., data through January 13, 2016. For illustrative purposes only. Past performance does not guarantee future results. 

Do a Little Math

Finally, the ratio of puts to calls hasn’t seen the same dramatic spike as in August. According to data from the OCC, the put-to-call ratio for trading across all the exchanges hit an extreme of 1.47 on August 21 and remained historically high at 1.35 on August 24.

To some observers, it was a sign that investors were heavily trading put options for a short-term hedge on stocks and portfolios for fear of further market losses. Figure 3 shows the extreme spike in the ratio in mid-August, and that the ratio (which is simply put volume divided by call volume for all contracts traded on the exchanges) has not yet approached the same extreme levels in mid-January 2016. The highest reading so far is a 1.22 on January 8.

One-year view of multi-exchange option put-to-call ratio

FIGURE 3: OPTION MARKET CLUES?

This one-year view of the multi-exchange option put-to-call ratio shows readings below those recorded in the volatile summer. Source: Options Clearing Corp., data through January 13, 2016. For illustrative purposes only. Past performance does not guarantee future results. 

In short, unlike August 2015, there has been no “washout” or the churn of stock capitulation reflected in VIX and/or the put-to-call ratio. The underlying tone is certainly cautious, but it hasn’t seemed “panicky” so far if you ask most veterans on the Street. It simply means that investor sentiment doesn’t seem to have reached the same depressed levels of the Dog Days of August.


Tom White’s RED Option Strategy of the Week:

Iron Condors: Volatility Can Bring Opening Opportunities

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

Raging volatility tends to expand option premium, as the uncertainty in the market typically has option traders out in full force. Specifically, the additional option premium and uncertainty tends to lure some traders to attractive entry points for risk-defined credit spreads.

Risk-defined strategies such as short verticals and iron condors draw added attention when volatility increases. The short iron condor is a strategy used by some option traders to take advantage of a range-bound market or stock. By definition, an ideal time to sell an iron condor is when volatility rises and you expect the price of the underlying to remain in a neutral or range-bound area.

Iron condors involve 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’re typically both out of the money and each vertical is equal width apart. There’s 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 the amount that can be profit as you collect a credit for the trade. This is why high volatility provides potentially attractive opportunities for some option traders, as option premium expands so, too, could the credit.

How do I profit on a short iron condor position? To maximize this neutral strategy, the outlook typically calls 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 transaction costs) that you collected when selling the iron condor. The risk involved in the position comes into play when the underlying trades outside of either the downside or upside breakeven prices. The ideal scenario is for the underlying to trade between the short verticals; the breakeven levels are the amount collected minus the width of the strikes in the verticals. 

Now, don't expect that ideal situation to occur every time. Typically, we would prefer to close the position as close to expiration as possible for less than the amount collected. This will eliminate some risk of the underlying security moving significantly ahead of expiration while we’re still exposed. Time decay, or theta, typically works in our favor with this strategy because the short verticals that comprise the position lose value each day into expiration.

There are two breakeven points for the iron condor position:

• Upper Breakeven Point = Strike Price of Short Call + Net Premium Received

• Lower Breakeven Point = Strike Price of Short Put - Net Premium Received

Click for more strategies including a video example of an iron condor strategy from RED Option.


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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