Market conditions change often. One old adage tells us that “history rhymes rather than repeats,” which is certainly true of the markets. And that uncertainty can have important implications for the investment decisions we make.
Six months ago, for example, I was droning on and on about the collapse of market volatility, a little like a weatherman lamenting the lack of rainfall in Death Valley. Well, when it rains it pours, because the CBOE Volatility Index (VIX) is well above its summer 2015 lows. Recall that, in early August, VIX hit lows just below 11 for the first time in nearly a year (figure 1).
The August lows in the volatility index proved to be an important turning point that few investors seemed to anticipate. Since VIX reflects the implied volatility priced into short-term options on the S&P 500 Index (SPX), the low readings indicated that market participants were expecting or “pricing in” relatively quiet stock trading to continue.
Obviously, what happened next defied those expectations, as volatility saw a major spike through August and remained elevated in September. After trending lower in October and November, VIX started climbing again in December and has remained above 20 through much of 2016.
A Closer Look
Let’s dig deeper. The term structure of SPX, or what I call the VIX “curve,” has changed quite a bit over the past six months. In early August, short-term volatility was near 11, but as we can see from figure 2, it steadily increased for later expirations. Still, by November, it stood at 15, and in January, at 16. Boy, did the options market have it wrong!
The steepness of the VIX curve in August 2015 may have reflected some faulty volatility perceptions, but that’s not unusual. This so-called “contango” reflects the fact that, among other factors, there is typically more uncertainty over longer periods of time, and options are priced accordingly.
Fast-forward to the present day (figure 3), and the curve has flattened noticeably. When VIX was near 11 in early August, the longer-dated January 2017 options were near 20. Longer-term volatility was 9 points, or more than 80%, above the short-term options. Now VIX is in the low 20s, and the very longer-dated vols are only in the mid-20s. There’s really not much of a gap between the two.
What’s It Mean?
Is the flatter VIX curve the options market’s way of saying that volatility is not likely to move significantly higher from current levels? Or is this another case of market participants underestimating the potential for volatility to increase during the rest of 2016? Only time will tell.
Tom White’s RED Option Strategy of the Week: Vertical
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Market opinions, analyst expectations, and news-driven events can all affect the price of an underlying stock or index. Anyone who’s caught a whiff of this revived option volatility is well aware. One strategy that some traders believe can take advantage of this scenario is the vertical spread—specifically, short vertical spreads that receive a credit upon initiation.
A short vertical’s higher option premium typically allows for higher probabilities of success, higher credit received (which aims to reduce the overall risk), and a wider range of picks away from the current share price of the underlying instrument.
Although long verticals are risk-defined and can be a useful way to take a directional stance, short verticals are intended to give you a cushion and better probabilities of success due to the distance away from the current share price. Time decay, or theta, also works in your favor as the price of your short vertical loses value each day into expiration.
In fact, verticals are the most basic option spread. The thrust behind verticals is hedging one option with another: when one makes money, the other loses money. You also reduce your risk on the directional position.
The idea is that in exchange for relatively low risk, you give up the possibility of massive gains. But don't fret: verticals (either a bullish vertical or bearish vertical) are popular with investors because of the limited nature of their risk, and profit potential that, although limited, can still amount to a motivating factor for some traders. (you’ll have to factor in transaction costs, too).
What is the difference between selling a vertical and buying a vertical? By selling, traders typically can take advantage of time decay (theta) and probabilities. It is an approximation of the decrease in the price of an option over a period of time when all other factors are held constant. Theta is generally expressed on a daily basis. For example, if a call has a price of $3.00 and a theta of $0.10, one day later, with all else unchanged, the call would have a price of $2.90 ($3.00 - (.10 x 1)). By selling a vertical, that trader collects a credit on the trade. Positive theta will lower the value of the vertical on a daily basis even if you sit idle. If all factors stay the same, you’ll be able to buy the vertical back for less or allow it to expire worthless at option expiration.
In many stocks, option volatility and margin requirements are so high so as to prohibit either buying or selling options outright, whereas verticals typically do not incur such obstacles. Verticals can offer investors an efficient way of creating long or short exposure in a stock.
A little baseball analogy may help: A vertical spread allows you to hit singles, doubles, or even take a walk when taking a directional stance on a trade. Swinging for the fences can be an expensive way to trade.
Spreads 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.
Free: 2 Strategies for 2 Months*
Get step-by-step TradeWise trade ideas from veteran floor traders delivered directly to your inbox. At checkout, enter coupon code “ticker” to get 2 strategies for 2 months free.