The S&P 500 was at record highs 11 months ago and, since then, the daily chart of the index has taken on a decidedly W-shaped formation. That’s because, a few months after those record highs, it trended lower, then took another run back toward its highs into early November, before falling again through mid-February, and then climbing again to its current levels. Given the up-and-down action since record highs were set on May 21, 2015, I thought it would be interesting to do a now-and-then comparison of VIX and various market sectors. So here goes.
How Low Can You Go?
Few market watchers would probably have predicted at the start of 2016 that the CBOE Volatility Index (VIX) would be back toward 12 less than five months later. VIX tracks the expected or implied volatility priced into a strip of S&P 500 Index (SPX) options and typically moves higher when the broader equities market moves lower. That pattern held throughout much of January and February. Recall that the market’s “fear gauge” started 2016 north of 20 and rallied to 2016 highs above 28 by February 11.
Yet, VIX has been trending lower since its February spike and dropped to just 12.5 last week. That, in turn, is the lowest reading from the volatility index since August 2015. In addition, at 12.5, the index is at roughly the same levels today as when the S&P 500 set record highs on May 21, 2015. On that day, the volatility index traded in a range between 12.09 and 13.09. As we can see from the VIX chart (figure 1), those low readings were followed by dramatic action in the summer months, including the spike into the 50s in mid-August.
Sizing Up the Sectors
Although VIX has returned to the levels seen at the previous market top, the S&P 500 is not quite there yet. It closed above 2100 last week, but is still 30 points shy of its all-time best levels. As of this writing (April 21), the S&P 500 is 1.8% below its record.
However, although the S&P 500 is not much changed in the past 11 months, there has been notable movement below the surface. That is, there have been notable winners and losers among the 10 market sectors that comprise the index. For example, utilities, consumer names, and telecom have advanced. Energy, basic materials, and health care have been the biggest losers.
|Since 5/21/2016||Since 2/11/2015|
|CBOE Volatility Index||15.2%||-50.4%|
Source: Frederic Ruffy, Data Sources: Standard & Poor's and Chicago Board Options Exchange.
Note that some of the sectors that have powered the S&P 500’s 14.3% rally since February are the same ones that are down the most since the highs of last year. Also, the sectors that performed the best since May 2015 are now lagging. This seems to suggest that investors were rotating aggressively to the underperforming sectors after the market bottomed in February.
Finally, we can see that VIX is up 15.2% since May 21, 2015, but has been cut in half since February 11, 2016. This is a somewhat remarkable change of sentiment in a little over two months’ time. But that no longer comes as such a surprise after nearly a year of dramatic ups and downs in both VIX and the S&P 500.
RED Option Strategy of the Week: Strangles
T.J. Neil, Sr. Specialist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Earnings season is in full swing which brings with it the potential for extreme movements in stocks releasing their quarterly results. Over the past two months, the market has experienced a sharp rally off the February lows. Sustained rallies in equities may go hand in hand with sharp drops in implied volatilities. As equities rally, the imbedded premium levels within options decreases. Perceived fear increases that premium and a lack of it reduces the extrinsic component of an option.
Usually with earnings approaching, option prices will rise to reflect the potential movement of the stock following the event. The recent rally brings with it an interesting dynamic. A low volatility environment can cause traders to “anchor” their pricing lower because of the recent selling pressure they have experienced. This scenario can bring with it the opportunity to place a trade that takes advantage of this potential mis-pricing.
A strategy that would enable a trader to pursue on this idea would be a long strangle. Whereas a long straddle is usually composed of buying an at-the-money call and put in the same strike in the same expiration cycle, a long strangle is created by buying an out-of-the-money call and put in the same expiration cycle. If a trader thought the options were under-priced and the stock was poised to make a large move on earnings, a strangle could be a good choice.
Let’s say stock XYZ is trading at $50.00 and it has earnings just prior to May expiration. If a trader believes the stock will move greater than $5.00, he could purchase the May 48 puts and the May 52 calls for anything less than $3.00 (including transaction costs) and be profitable if the stock goes below $45.00 or above $55.00. The total risk of this trade would be $300.00 per contract (plus transaction costs). The potential gain on the upside is theoretically unlimited. It’s calculated by adding the upside call strike to the premium amount and transaction costs paid for the strangle, and subtracting that from the stock price. On the downside, a gain is calculated by subtracting the strangle premium and transaction costs from the downside put strike and then subtracting the stock price from the difference.
Be aware that most of the time, a long strangle needs an extreme move in the stock for this strategy to be successful. There’s another situation that could turn this strategy into a winner without the stock moving. If the market perceives a strangle to be too low after purchased, there could be more buying until the market reaches an equilibrium. In this case, a trader could simply sell a strangle at a higher level and pocket the difference (minus transaction costs). Remember, the market does not always price everything perfectly. So when a trader finds that equity that has options which might be undervaluing a potential move, take a look at using a long strangle as a possible strategy.
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