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Volatility Update: Are Traders Bracing for Higher Volatility?

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May 26, 2016
The Sphinx's missing nose: This week's volatility update and option strategy

The theme of quiet trading continues in May. Since March, the S&P 500 has seen average daily point moves of just under 11 points, compared to moves of more than 16 points during the first three months of the year.

While equities move rather quietly from one day to the next, there has not been a lot of directional movement, either. In fact, at 2,050, the S&P 500 is at the same levels as it was in early April, mid-December, August 2015, and even November 2014. So what happens next? Will volatility continue falling? Not everyone seems to think so.

Home on the Range

While the equity market has been trading in a rather aimless fashion this month, the CBOE Volatility Index (VIX) is ticking a bit higher during the past couple of weeks. The market’s so-called “fear gauge” is back near 16 after falling to a low of 13.55 on May 10. However, as you can see from figure 1, at 15.7, the index is decidedly flat for the month and also within the recent range between roughly 13 and 17.

CBOE Volatility Index

FIGURE 1: VOLATILITY PERKS UP.

VIX edged higher in the first few weeks of May, but is down 14% for the year. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The so-called VIX “curve” shows how the current VIX stacks up compared to later expiration terms. Recall the VIX is a measure of expected or implied volatility (IV) of S&P 500 Index (SPX) options premiums, but it tracks only a strip of very short-term options.

Since each and every options contract has a unique level of implied volatility (computed using an options pricing model), more distant expiration months can have different levels of IV compared to the VIX. And as you can see from the graph from the CBOE website (figure 2), the term structure of VIX options is now steep. 

VIX term structure

FIGURE 2: VIX TERM STRUCTURE.

Implied volatility in S&P 500 Index short-term options is lower than longer-term implied volatility. Data and chart source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.

BOXing Pit?

Another development to watch later this year is recently announced plans for a new options trading pit. The Boston Options Exchange (BOX) announced this month that it wants to add to existing electronic markets by launching an open outcry venue in Chicago toward the end of 2016.

BOX is one of 14 options exchanges to list puts and calls on equities and indexes. So plans for a trading pit are a bit surprising given the trend has been in the opposite direction. In fact, only the Chicago Board Options Exchange operates trading pits for listed options (VIX and SPX contracts). The remaining 13 exchanges conduct most of their trading electronically.

Still, BOX says there’s a need for a pit to bring human faces together to trade more complex options strategies. Time will tell if a crowd indeed gathers to the BOX pit and if the market makers and floor traders can score a long-awaited victory against the machines that have decimated jobs and dominate the trading landscape today. The new trading pit is pending regulatory approval.

RED Option Strategy of the Week: Long Calendar Spreads

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

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

In the relatively low-volatility environment experienced over the past couple of months, it can be hard to utilize strategies that thrive in elevated volatility conditions. For traders looking for a strategy that takes advantage of an underlying that is range bound, with the potential for a rise in volatility, a long calendar could be a good fit. This spread has defined risk and takes advantage of the varied rate of time decay between the two legs of the spread. The maximum risk of this spread is the amount paid plus transaction costs. The profit potential depends on the value of the deferred-cycle option when the front option expires.

A long calendar is also known as a “time spread,” because it’s constructed by buying an option that expires further out in time than the one that is sold on the other side of the spread. The spread is composed of calls or puts. For example, if a trader were long a 17 Jun / 20 May call calendar spread, she would be long one 17Jun call and short one 20 May call and would pay a debit (or at least zero) to enter the trade. A further-dated option with the same strike price cannot be worth less than a near-term option because of the time value of money.

Ultimately, this strategy works best when the underlying spends a majority of its time near the strike price. An option will decay the most when it is at the money, and it decays more quickly as it approaches expiration. This action is one of the drivers that helps expand the value of this spread, and it occurs because the near-term option decays at a faster rate than the far-term option. This effect decreases as the underlying moves away from the strike. Additionally, a long calendar spread is a long vega position. This means that an increase in volatility would be a positive for this position and help to expand it.

One advantage of a long calendar is that the near-term short option can be rolled for a credit if the underlying is trading near the strike price. As the near-term series nears expiration, it will need to be “rolled” (or closed) to the next expiration cycle. This can be accomplished by buying back the current short option and selling the same strike in the next expiration cycle (if the underlying is relatively close to the strike price). These “rolls” can help reduce the exposure of the trade. 

With the advent of weekly expiration cycles, many actively traded contracts have an expiration every Friday. This gives a trader more opportunities to roll a position and increases the possibility of collecting more credits. 

Although most long calendars are executed with a strike price that is near the current underlying price, they can be placed away from the market. This turns the trade into a directional play. The advantage of placing the trade this way is the initiation price could be a lower debit than if purchased with a strike near the current underlying price.

For traders looking for a strategy that takes advantage of time decay, a range-bound market, and a low-volatility environment, a long calendar spread could be worth a look.

Multiple-leg option strategies can entail substantial transaction costs, including multiple contract fees, 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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