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Volatility Update: Return of Bullish Sentiment

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March 10, 2016
Awash in a sea of volatility: Super Tuesday plus a stock market rally equals easing volatility

The month of March was off to a strong start when, on "Super Tuesday" (March 1), the S&P 500 jumped 46 points and many measures of market volatility fell to their lows of the year.

Although the rally coincided with Presidential primary elections, the return of bullish sentiment lately probably has less to do with the events on the political front, and more to do with expectations for corporate earnings improvement in 2016.

The most widely watched measure of market volatility has certainly taken a hit in the early days of March. Put another way, a lot of fear came out of the market last week.

The CBOE Volatility Index (VIX), which tracks the expected or implied volatility priced into a strip of short-term options on the S&P 500, lost 2.85 points, or 13.9%. What’s more, after dropping to 16.7 a couple of days later, VIX dropped to its lowest levels since December 29.

volatility index, vix, vix and s&p 500

FIGURE 1: VOLATILITY DROPS TO NEW LOWS.

Last week, the VIX dropped to its lowest level since December 29. The drop in the VIX helped the S&P 500 rally. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

VIX and S&P 500: Inverse Relationship

The "fear gauge" often moves opposite to the S&P 500, and it’s sticking to that pattern lately. While VIX dropped from a 2016 closing high of 28.14 on February 11 to its 2016 lows south of 17 through March 3, the S&P 500 rallied by nearly 9%. The rally was broad-based, as nearly every market sector participated in the advance.

The table below shows that utilities were the one exception to the rule and were basically unchanged since February 11. Energy was a big mover, gaining 11.2% thanks to bubbling crude oil. Financials also saw relative strength during the advance.

Telecom                  14.5%
Financials                12.2%
Consumer Disc.       11.6%
Energy                      11.2%
Materials                 10.5%
Industrials                 9.5%
Technology               8.8%
Health Care              5.9%
Consumer Staples    3.8%
Utilities                     0.2%
S&P 500                   8.4%

Data from February 11, 2016 to March 3, 2016.

Oversold Energy and Financials Lead the Way

Relative strength in energy and financials is noteworthy because these two sectors delivered the worst fourth-quarter earnings. According to Zacks Investment Research, with most of the member companies having released results for the period, both sectors saw year-over-year earnings declines of nearly 17% during the period.

Looking forward, the next earnings reporting season doesn’t get into full swing for another month. However, the outlook has not really improved. In fact, according to Zacks, first-quarter results for the S&P 500 are expected to be down 9.3% from a year ago, with energy once again being the biggest drag on performance. That’s even worse than the 6.1% year-over-year profit decline of the fourth quarter 2015.

In conclusion, while March 1 was Super Tuesday for Presidential hopefuls, the super rally on Wall Street that day seems to have little to do with politics. Instead, the rally, and subsequent dive in VIX, seems to be expressing confidence that corporate earnings are set to improve, especially in some of those sectors that have performed miserably lately like energy and financials.

Those expectations will likely be tested a month from tomorrow when the first S&P 500 member releases results and kicks off the first-quarter earnings parade on April 11. 

RED Option Strategy of the Week

TJ Neil, Sr. Specialist, RED Option

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

The new year brought a new level of volatility to the markets. This type of movement can strike fear in many, but for option traders, this price action can signal something different: potential opportunity. With heightened risk levels, options traders can employ one of the building blocks of risk-defined trading: vertical spreads. Verticals are a logical next step for those with experience trading individual calls, puts, and covered calls.

There are different types of vertical spreads, but the mechanics are similar from one type to the next. A call vertical, for example, involves simultaneously buying one call option and selling another call option at a different strike price in the same underlying, in the same expiration month. Similarly, a put vertical involves simultaneously buying a put option and selling another put option at a different strike price in the same underlying, in the same expiration month.

Among call and put vertical spreads, there are two types: credit and debit. To create a credit spread, traders sell an option with a high premium and buy an option with a low premium. To form a debit spread, traders purchase a high-premium option and sell an option with a low premium.

The amount of risk in a vertical credit spread is determined by the width between its strikes minus the credit received. The maximum potential profit, minus transaction costs, for a vertical credit spread is the premium collected when selling the spread. For example, if a trader sells an XYZ 102/104 call vertical for $0.60, the risk is $140 per contract and the maximum potential profit minus costs is $60 per contract. 

Vertical Credit Spread Characteristics

  • Risk per contract = (width of spread – credit received) x 100
  • Max profit per contract = credit received x 100, minus transaction costs

For the XYZ example:

  • Risk = $140, or ($2.00 – $0.60) x 100
  • Max potential profit = $60 ($0.60 x 100), minus transaction costs

When buying a vertical debit spread, the risk is whatever a trader pays for the spread. The maximum profit is determined by subtracting the premium paid for the spread from the width of the spread. For example, if a trader buys a FAHN 197/194 put vertical for $1.20, the risk is $120 per contract and the maximum potential profit is $180 (minus transaction costs).

Vertical Debit Spread Characteristics

  • Risk per contract = the amount paid for the spread x 100
  • Max profit per contract = (width of spread – amount paid for spread) x 100, minus transaction costs

For the FAHN example:

  • Risk = $120 ($1.20 x 100)
  • Max potential profit = $180, or ($3.00 – $1.20) x 100, minus transaction costs

Now that you understand the basic characteristics of vertical spreads, let’s talk about their versatility. The vertical spread is a directional play that allows a trader to be bullish or bearish based on the way the spread is executed. It can also be used to capitalize on inflated or deflated volatility levels.

Let’s say a trader thinks a stock is oversold and volatility levels are due to decrease. In this case, selling an OTM (out-of-the-money) vertical put credit spread might be appropriate. Selling a vertical put credit spread is a bullish strategy, which also potentially profits from a decrease in volatility. On the other hand, let’s say a trader believes a stock is overbought, has extremely low volatility, and low premiums in the options. This might be a time to buy an ATM (at-the-money) vertical put debit spread. This is a bearish strategy that could profit from an increase in volatility.

These are just a few of the ways that vertical spreads can be used to place directional trades on an underlying stock in a risk-defined manner. And you might start to see how these trades can be versatile and applied in a variety of market conditions. 

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.

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