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Volatility Update: Sizing Up Volatility Spikes

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April 7, 2016

The S&P 500 eked out a small gain of less than 1% during the first quarter of 2016, but the modest advance masks an otherwise up and down quarter for the equities market. Indeed, it was a 6.6% rally during March that recently buoyed the S&P 500 into positive territory for the year. Prior to that, the index was deep in the red.

Meanwhile, a notable decline in market volatility occurred during the March rebound, but some longer-term options on the S&P 500 might be priced for a potential return of volatility in the second half of 2016.  

Not Just VIX

CBOE Volatility Index finished the first quarter down 23.1% after a sharp fall during March. The market’s “fear gauge” finished February north of 20, but was below 14 just one month later.

Since VIX tracks the expected or implied volatility priced into a strip of S&P 500 options, it’s not surprising to see the move lower when the equity market moves higher. And, as the S&P 500 hovers at its best levels of 2016, the volatility index is not far from is low point of the year.



A one-month 33% drop in VIX coincides with a turnaround in the S&P 500. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

As noted last week, the decline in volatility is not limited to VIX. The table in figure 2 shows the trend in the first quarter and during the month of March. Implied volatility in the Dow (VXD) and NASDAQ (VXN) fell sharply as well. Oil Volatility (OVX), Gold Volatility (GVZ), Euro Volatility (EVZ) and China VIX (VXFXI) also saw sharp declines in March. Brazil (VXEWZ) is the exception and bucking the trend, as turmoil in their political system rattles equities markets.  



Most measures of volatility experienced sharp drops during March. Date source: CBOE. Image source: Fred Ruffy. For illustrative purposes only. Past performance does not guarantee future results.

In Simple Terms

Longer-dated S&P 500 Index options paint a slightly different story than the sharp fall in many of the volatility indexes in figure 2. The Chicago Board Options Exchange posts the real-time and historical term structure of VIX options daily on its web site.

The curve in figure 3 depicts implied volatility of SPX options across different expiration months. For example, while April options have volatility of only 12, the curve shows the values steadily increasing and reaching more than 20 in December. 



Most of the collapse in SPX implied volatility has been in the short-term options. Data source: CBOE. Chart source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

In other words, while VIX reflects the volatility in a strip of very short-term SPX options, it does not depict volatility perceptions across the entire curve. The relatively steep term structure across later expiration months is notable, as it rises quickly through the summer and into the end of 2016.

Only time will tell whether or not the VIX term structure is correctly “pricing in” the potential for future market volatility in the second half of this year. There are certainly a number of unknowns ahead, including the Federal Reserve’s course on interest rates, a murky corporate earnings outlook for the second half of 2016, and, of course, the still unfolding 2016 presidential race. 

RED Option Strategy of the Week

T.J. Neil, Sr. Specialist, RED Option

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

After a roller-coaster start to the year, we have seen a significant pullback in the volatility levels of just a month ago. With earnings season right around the corner, it’s a good time to think about adding a new arrow to your quiver. One strategy designed for these types of scenarios is the long butterfly. This strategy aims to take advantage of elevated levels in volatility, in a risk defined manner. 

Let’s say you want to place a trade that takes advantage of an elevated volatility level in a particular underlying that you believe is ready to consolidate near a certain price. A long butterfly might be a potential solution.

This strategy is a 3-legged spread that is created by selling 2 middle strike options, buying 1 lower strike option, and buying 1 higher strike option, using either calls or puts in the same expiration cycle.

When buying a butterfly spread, the maximum risk is the net debit paid for the spread (plus transaction costs).  The maximum potential profit would be the difference between the middle and lower strikes minus the debit paid for the spread (plus transaction costs). To achieve this the underlying would need to settle at the middle strike price at expiration. A maximum loss would be realized if the underlying settles either below the lower strike or above the higher strike at expiration.



 The middle strike price in this example long butterfly is 105. The “wings,” or higher and lower strikes, are 110 and 100. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

So why is this spread called a butterfly?  Many believe it comes from the shape of the position’s profit and loss graph. The “body” is represented by the peak at the middle strike that runs down to the lower and higher strike. The “wings” are formed by the flat lines running straight out horizontally from the lower and higher strikes. 

In the profit and loss graph in figure 4, the underlying is trading at $105.13 and the position displayed is long 1 May 100/105/110 call butterfly purchased for $1.00. The max loss would be $100 per spread (plus transaction costs). This would occur if the underlying closes below $100 or above $110 at expiration. The maximum potential profit would occur if the underlying closes at $105, and the profit could be as much as $400 per contract (minus transaction costs). The breakeven levels for this position (not including transaction costs) are $101 on the downside and $109 on the upside.

Trade placement should be based on where you think the stock is going to be at expiration, not where it is right now. This is because most of the expansion in the butterfly will occur near expiration. Let’s say that the underlying in the example above was trading at $105, but we thought it would be at $110 by May expiration. In this case, you could buy the May 105/110/115 call butterfly, so the trade could reach maximum profit potential at your target price. 

Although, volatility is relatively low right now, it probably won’t be here forever. The next time you want to trade a risk-defined strategy designed to take advantage of a temporary rise in volatility, you might think about trading a long butterfly.

Spreads, butterflies, 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 and are not suitable for all investors.

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