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Volatility Update: Trading Records and Broken Records

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January 7, 2016
Volatility update: juggling implied options, skew, emerging markets, and the new year

Wall Street whimpered into year-end, leaving the S&P 500 (SPX) down 15 points, or 0.7%, for all of 2015. Remember 2015? It also featured record-high territory for the broad-market average at one point.

Wall Street, of course, yelped to start 2016. But we’re interested first in a little recent history. Late-year trading was bound by fairly narrow ranges and a stock market tethered to oil’s every whim. Daily themes played like a broken record.

The lack of movement in the SPX over the 12 months is a bit deceptive, however, as it was certainly a year of ups and downs. And traders wasted little time in stirring up Wall Street to launch 2016 trading—stocks tumbled some 2% to 3% and the CBOE Volatility Index (VIX), the market’s “fear gauge,” again pushed above the closely watched 20 line.

A deeper plunge into key 2015 stats reveals a fairly volatile year, all told—a year of broken records in more ways than one. And on the dawn of a new trading year, that action begs the question: could more mood swings drive 2016 trading?

VIX Volatility gauge

FIGURE 1: VOLATILITY ROARS TO LIFE.

This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” back above 20 to start 2016. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Crank Up the Volume

One record set last year was the one-day trading volume on the Chicago Board Options Exchange. According to the exchange, more than 11 million contracts traded on its venue on August 21. That, in turn, surpassed a previous record of 10.9 million from August 8, 2011. CBOE is one of more than a dozen exchanges and, on August 21, more than 40 million options traded across those exchanges—the second-busiest exchange-wide day ever.

A few days after the CBOE logged those record levels of trading activity, the VIX jumped to a high of 53.29. A record? Nope, not by a long shot. But a strong reading, nonetheless.

Notably, the heat did turn up elsewhere. The CBOE Emerging Markets ETF Volatility Index (VXEEM) notched all-time highs on August 24. While VIX tracks the implied volatility priced into short-term SPX options, CBOE created the emerging markets “VIX” to gauge the volatility across equities markets of developing economies including China, Brazil, and Russia. VXEEM hit what most traders would consider an extreme at 111.39 on August 24.

Not to be outdone, the S&P 500 Correlation Index (ICJ) hit new highs last year as well. ICJ tracks the degree of co-movement, or correlation, among individual S&P 500 stocks. When macro events trigger wild action in equities markets around the world—say, when China’s economy sputtered in August—ICJ tends to move higher. A falling correlation index reflects mixed trading and declining correlations. The index’s August 24 spike to 117.63 is easily the highest reading on record for the index.

And then there’s market skew. The CBOE Skew Index (SKEW) hit new highs in October. The term skew describes the difference in implied volatility across different strike prices and/or expiration months in specific underlying securities, such as stocks or indexes. The Skew Index is the implied volatility of SPX options (like VIX), but of option contracts that are very deep out of the money and sometimes used to hedge portfolios. Stated differently, the Skew Index helps measure the premiums investors are paying for put options that have strike prices well below the current levels of the S&P 500. SKEW hit an extreme of 151.22 in mid-October and remained elevated at 140 in late December.

Volumes on CBOE hit all-time highs and, judging by the extremes in ICJ and VXEEM, global equities recorded periods of unprecedented volatility as well. Take these factors, toss in that Skew Index, and conclude that the new year could carry over some of that investor anxiety.

Tom White’s RED Option Strategy: Covered Calls—Time for a Shopping List?


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

Volatility is rising and option premium is expanding amid fresh global uncertainty. Are select stocks that you’ve had an eye on starting to near an attractive entry point? Is it time to look for some long-term positions in equities?

If so, one approach may be the "buy-write." Buying the stock and selling the call at the same time is called a buy-write; once created, the position becomes known as a covered call. If a trader buys the underlying instrument at the same time he or she sells the call, the strategy is a buy-write. Implementing this strategy involves buying (or owning) 100 shares of a stock and then selling a call that is "covered" by the stock (since 1 option contract usually controls 100 shares of stock). The long shares in the underlying instrument are said to provide the "cover," as they can be delivered to the buyer of the call if the buyer decides to exercise it.

“Writing” the call generates income, as the trader pockets the premium received. The position is used to potentially enhance the overall return of a long or bullish trade (minus transaction costs), but it also lowers the initial breakeven price of the underlying stock. Of course, the strategy will limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.  

Some traders consider the strategy when stocks get beaten down or the trader thinks the stock may be ready for a rebound or consolidation. This strategy is typically best used when the investor would like to generate income off a long stock position if he believes the price will be moving sideways or slightly higher. It allows the trader to continue a buy-and-hold strategy. The trader must correctly guess that the stock won't make substantial gains within the time frame of the option, which is best done by writing an out-of-the-money option. Although gains are capped because of the short call, should it go in the money at expiration, any rise in the shares above the strike should still be a profitable trade. A covered call doesn't have as much potential for reward as other types of options, so the risk is also relatively low.

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