So far, 2016 is shaping up to be another year of roller-coaster action on Wall Street. After falling sharply in the first few weeks of January and stumbling again in early February, the S&P 500 (SPX) forged a solid advance off its February 11 lows and is now (through February 25) setting two-month highs.
Meanwhile, market volatility, which saw a notable spike as the SPX faltered in the first few weeks of this year, has been trending lower since February 11. In fact, more than one measure of volatility is now setting fresh 2016 lows.
The CBOE Volatility Index (VIX) recently dropped below the 20 level and to new 2016 closing lows. The index started the year in an uptrend, as it had risen from a December 24 low of 14.45 to higher than 20 through the first day of trading in January. It finished at 19.34 on January 5, and that was the lowest close for 2016 until it closed at 19.11 last Thursday.
Fear Gauge Dropping
The new 2016 lows in VIX (figure 1) suggest that risk perceptions are easing a bit. VIX is sometimes called the market’s “fear gauge” because it often spikes during times of market turmoil and when portfolio managers scramble to buy puts to hedge stock positions. That’s because VIX measures the expected or implied volatility priced into a strip of SPX options that are among the more widely used tools to protect or hedge portfolios. When the VIX increases, it’s usually a sign that portfolio insurance (i.e., SPX option premiums) is getting more expensive.
Volatility of Volatility: The VVIX
While VIX is suggesting the underlying tone of the market is becoming a bit less defensive, the volatility of VIX options is telling an interesting tale as well. VIX has listed options that trade on the Chicago Board Options Exchange (CBOE) and are often used to hedge volatility risk. The exchange has created a convenient tool for tracking the volatility of VIX options. Just as VIX tracks the implied volatility of SPX options, the VVIX (figure 2) is designed to track volatility priced into a strip of short-term options on the VIX. In short, the VVIX measures the volatility of volatility. Let that soak in for a minute.
VVIX rallied to record highs of 212 on August 24 before falling sharply through late November. It started bubbling again toward the end of 2015 and hit a high of 135 in mid-December. It then spent January chopping around before dropping sharply beginning in mid-February. At 83.5, VVIX isn’t just at 2016 lows; it’s at levels not seen since early August 2015.
Without a doubt, the wacky up and down action certainly has Wall Street on edge in 2016. Lackluster earnings, unpredictable moves in energy prices, uncertainty about Federal Reserve policy, and turbulent trading in overseas markets have conspired to cloud the outlook for the economy and the equities market. Yet, the recent decline in VIX seems to suggest that risk perceptions are easing a bit after remaining elevated in the early part of 2016. In addition, the new lows in VVIX possibly indicate that some players in the index market expect a return to normalcy as well.
Tom White's RED Option Strategy of the Week: Covered Call
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
The overall market was flat in 2015 and downside pressure built up. Volatility rose and option premiums expanded amid the uncertainty. At the start of 2016, global stocks were getting dragged lower as geopolitical and growth worries mounted. But after last week’s rebound, many traders are wondering if markets have stabilized. Are some stocks nearing long-term entry points? Is it time to look for some long-term positions in stocks?
One strategy to look at in this current environment is the covered call, or its cousin the buy-write. This is because markets are showing signs of stabilizing, and premiums in options are still elevated thanks to relatively high volatility. (Although, as Fred noted above, volatility has been falling and seems to be returning to historically normal levels.)
Constructing a Covered Call
Implementing a covered call involves selling one call option against 100 shares of stock in a portfolio. The call is "covered" by the stock because one option contract usually controls 100 shares of stock. The long stock is said to provide the "cover," as the stock can be delivered to the call buyer if she decides to exercise. Selling, or writing, the call generates income for the writer, minus transaction costs. This income can potentially enhance the overall return of an investment, and it lowers the breakeven price of the underlying stock.
A buy-write is just like a covered call, except the stock isn’t already in a portfolio. Implementing a buy-write involves simultaneously buying 100 shares of stock and selling, or writing, a call option against the stock.
These strategies may be worth a look after stocks get beaten down and may be ready for a rebound. Additionally, these strategies might be beneficial to options traders who want to generate income off long-term investments when the market is moving sideways or slightly higher. That’s because a covered call allows a trader to continue a buy-and-hold strategy and potentially earn income while a stock is moving sideways.
One risk a trader must anticipate is that a stock could make substantial gains before expiration of the call option. Should that happen the stock would likely be called away and sold at the strike price. A way to lower this risk is by writing an out-of-the-money option. Although gains in the underlying are capped due to the short call going in the money prior to or at expiration, any rise in a stock above the strike price will still be a profitable trade. The trader just won't participate in the stock's appreciation above the strike price, because the stock was called away. But it’s important to understand that a covered call doesn't have as much potential for reward as some of the other more risky options strategies. The strategy can, however, benefit from falling volatility since the trader is short a call option. This is because out-of-the-money options tend to be more sensitive to changes in volatility.
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