Market volatility picked up in the final two days of April, but it was an otherwise quiet month on Wall Street. The S&P 500 finished nearly unchanged for the month, and the average daily moves in the index were roughly 10 points, which is well below the average daily moves of almost 18 points seen during the first three months of the year. Now, as the equities market enters what some see as a seasonally weak period, some market watchers are likely wondering whether the subdued market action throughout most of April has set the table for a more substantial correction in the months ahead.
Springing Back to Life
The CBOE Volatility Index (VIX) perked up late last week after falling to the lower end of its six-month range through mid-April. Recall the VIX has been dubbed the market’s “fear gauge” because it tracks the expected or implied volatility priced into a strip of S&P 500 Index (SPX) options, and often moves higher during periods of market turmoil. But as the S&P 500 rose sharply from mid-February to the middle of last month, VIX fell from the high 20s to a 2016 low of 12.5 on April 20.
Figure 1 shows the recent action in the volatility index. Although it rose sharply in the last few days of April, it remained within a tight range of between 13 to 17 throughout the month. This range is well below the levels seen in the first few weeks of the year, when it closed nearly every trading session above 20. In fact, at 13, the index was probing levels not seen since October 2015.
It’s in the VIX
Looking at the performance of VIX from the past 10 years confirms that it has indeed dropped to relatively low levels. The table below shows the average VIX readings by month since April 2006. The grand total, or the average of the past 10 years, is 20.6 (last row). So even after the jump toward 17 late last week, VIX is well below the average readings from the past 10 years.
Looking month-by-month, April has historically been a quieter month for VIX with an average reading of 18. May and July have also seen lower readings from VIX, but then the numbers increased steadily until hitting their highest levels in October and November.
There’s an old adage on Wall Street that you've probably heard many times: “Sell in May and go away.” It refers to the belief in a seasonally weak period for equities spanning through the summer months and into October. According to Barron’s, the S&P 500’s average performance from May to October since 1950 is 1.3%. But from October to April, it’s 7.1%.
Volatility, on the other hand, has in the past tended to pick up in the fall. That is, when looking at the average readings from VIX, the historically volatile months of the year are in October and November.
All this is to say that April was a quiet month on Wall Street in 2016, and VIX stayed in a range well below its average levels of the past 10 years. Indeed, April has produced the lowest average readings from VIX over the past decade. Volatility has sometimes picked up into the summer as the equities market entered a seasonally weak period, but the most volatile months, according to the historical data of the VIX, were later in the year, before market action slowed again into the holidays.
RED Option Strategy of the Week: Butterfly
Tom White, Director/Strategist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Stocks have seen some downside recently and volatility has been perking up. It could be a fruitful period for option traders, as premium has expanded amid the uncertainty in the markets. The recent moves in underlying instruments and volatility may provide risk defined trading opportunities.
With anticipation of a normalizing market and volatility eventually falling, one strategy we look at is the butterfly. A butterfly is a risk-defined, non-directional options strategy that’s designed to typically have a favorable risk-to-reward scenario in the setup. It’s a neutral options strategy that combines bull and bear spreads using either all calls or puts.
Butterfly spreads use four option contracts with the same expiration series but three different strike prices to create a range of prices for potential profit. To construct a butterfly, a trader sells two option contracts at the middle strike price, buys one option contract at a lower strike price, and buys one option contract at a higher strike price. The “body” of the butterfly is the short strikes, while the “wings” are the long options on either side of the shorts. Butterfly spreads have defined risk because a trader can define the profit and loss when entering the trade.
The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents, plus transaction costs. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices, minus transaction costs. The maximum risk is limited to the net debit paid for the position, plus transaction costs. Butterfly spreads achieve a maximum profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration adjusted for transaction costs.
Although the object is to have the underlying instrument at its midpoint (body), it’s also a timing position. The butterfly takes a while to expand in price. The optimal time to close or exit the trade is as close to expiration as possible. An old adage we used on the CBOE trading floor was “butterflies can be cheap as far as price … but they’re cheap for a reason.” This goes back to the difficulty of timing and price action around the short strike in the trade.
Free: 2 Strategies for 2 Months*
Get step-by-step TradeWise trade ideas from former floor traders delivered directly to your inbox. At checkout, enter coupon code “ticker”.