The 1941 comedy film Sullivan’s Travels featured a popular director named John L. Sullivan who had achieved a great degree of success producing whimsical comedies like the 1939 film Ants in Your Plants. Despite his achievements, Sullivan wasn’t totally satisfied with his work. So he asked his boss if his next project could be a rather serious story about the plight of the poor and downtrodden of the day. The film he wanted to produce would be an adaptation of a fictional book titled O Brother, Where Art Thou.
Plight of Volatility Traders: Where’s the Vol?
If there are poor and downtrodden players in the options market in recent weeks, it might be the volatility traders, because the recent grind higher in the S&P 500 has been slow and methodical. In fact, the average daily range in the S&P 500 over the past month (through June 9) has been less than 10 points. There have been no moves greater than 28 points during that time. In fact, the last one-day move in the S&P 500 of more than 30 points was in mid-February.
Meanwhile, the CBOE Volatility Index (VIX) perked up a bit last week and moved to roughly 14.5 going into the weekend, but as you can see in figure 1, the index has been trading in a narrow range for the past few months and was probing 2016 lows into the early days of June. In addition, a sometimes seasonally slow “summer doldrums” might soon set in. Notice that VIX hit its 52-week lows of 10.88 in early August last year.
Let’s Get Real: Historical Volatility
The lack of substantial movement in VIX isn’t too surprising if one considers the nature of the market’s latest advance. The average daily moves in the S&P 500 have been small, and this quiet nature of the market is also noticeable when looking at the statistical, or historical, volatility of the S&P 500. VIX is a gauge of expected, or implied, volatility priced into a strip of S&P 500 Index (SPX) options, but historical volatility is computed as the annualized standard deviation of closing prices of an underlying security over a period of days. Like implied volatility, historical volatility (HV) is calculated as a percentage.
The 60-day HV of the S&P 500, for example, is plotted in figure 2 along with the S&P 500 daily chart. While the S&P 500 has been chopping higher over the past few months, 60-day HV is down from more than 20% in March to just 9.4% today. HV has dropped to its lowest levels since June of last year.
The HV reading of less than 10% might help explain why VIX remains at low levels. After all, the S&P 500 is trading rather quietly and therefore premiums should reflect the recent trend. In fact, at 14.5, VIX is substantially higher than the market’s actual volatility and seems to be suggesting that some market participants expect higher volatility in the future compared to the recent past.
Also keep this in mind: the last time 60-day HV was this low, the S&P 500 was again near current levels, but then fell sharply during August last year. That’s when VIX saw a spike above 50. Therefore, while volatility traders might be pondering “where art thou?” today, the answer might very well be: just around the corner.
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RED Option Strategy of the Week: Double Calendars
T.J. Neil, Sr. Specialist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Markets have recovered from the lows earlier in the year and volatility levels have waned. Although the broader market is near all-time highs, there have been more than a few ups and downs along the way. A strategy that is designed for a lower-volatility environment with range-bound price action is the double calendar.
The double calendar is a multi-legged option strategy. It's a range-based trade that has a wider breakeven range and a greater probability of potential profit than an individual calendar spread.
In a previous article, I discussed long calendar spreads. If you happened to miss that piece, here’s a quick overview to get you up to speed: Calendar or time spreads have options in two different expiration cycles or series, with the options being both calls or both puts. Calendar spreads involve buying an option in one expiration cycle and selling another option in a different expiration cycle, but with the same strike. Long calendars involve purchasing the further-term option and selling the near term-cycle so that the position remains risk defined. The strategy seeks to take advantage of the underlying trading at or near the strike price, with the highest potential for profit occurring in a rising volatility environment.
The double calendar is a combination of two calendar spreads. Traders typically buy an out-of-the-money call calendar and put calendar around the current underlying price. The result is a trade that’s range-based, like the neutral single calendar. But instead of having a profit peak at just one strike price, the double calendar has the potential for profit over a wider range of prices. Similar to the single calendar, the double calendar is designed to benefit from an increase in implied volatility (IV). A double calendar has two peaks or price points where the largest gains can be achieved. This max gain potential can change based on changes in implied volatility.
The price paid for the long double calendar is the risk involved in the spread. With a long double calendar, traders typically adjust or close the trade for credits, and the ideal scenario is for the underlying to move toward either strike. Although an increase in volatility would work best for the strategy as it moves close to either strike in the position, time decay (theta) also works in favor of the trade. This occurs because the short near-term options tend to lose value faster than the further-term long options in the trade.
Figure 3 shows a typical double calendar risk/reward graph with the optimal profitability near either strike.
Another potential benefit for long calendar trades is that although the initial risk is defined, the profit potential can increase as volatility rises. This is one reason initiating long calendars in a low-volatility environment is beneficial.
To wrap up, if you expect a move and volatility is low, a double calendar may be a strategy to consider, as it gives you a wide range and a risk-defined downside. Please remember that calendar, double calendar, and other multiple-leg option strategies like these 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.