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Volatility Update: Five Indicators to Watch Right Now

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June 2, 2016
Vise grip: This week's volatility update looks at five indicators to watch, plus vertical option spreads.

The “summer doldrums” refers to a sometimes seasonally slow period on Wall Street when the weather outside warms and volumes slow as traders leave for vacation. However, trading already sank into a bit of a lull in May 2016 and, therefore, it’s impossible to predict whether market volatility will move higher or lower going forward. It’s already at the lower end of the 2016 range. Fortunately, there are more than a few indicators that can give us a better sense of whether market participants are positioning for a bit more volatility through the summer and fall. Here are five.

Options Volume Waning

Has anyone ever told you that “volume is the engine that makes the volatility train go choo choo?” Me, neither. But it’s often true that volatility and volume go hand in hand. In May, for instance, average trading volumes across the options markets fell to an average daily rate of roughly 15 million contracts. While that’s robust trading activity, it’s down from 16.1 million in April and 15.4 million in May last year.

The decline in volume occurred during a relatively quiet four-week stretch for the stock market. The S&P 500 saw average daily moves of roughly 10 points and, with two trading days remaining in May, was up a modest 15 points or 0.7% month to date. Looking forward, overall trading volumes are often light during June and July. So if the numbers begin increasing in 2016, the uptick in volume could be an early sign that players in the options market are positioning for a potential vertical move and increasingly taking positions in puts and calls to express that view.

If you’re interested in keeping track of options volume, daily volume statistics can be found on the Options Clearing Corporation website.

The Fear Gauge Reads Complacency

CBOE Volatility Index (VIX) is sometimes a forward-looking indicator for market volatility. That’s because it tracks the expected, or implied, volatility priced into a strip of S&P 500 Index (SPX) options. The VIX tends to spike when investors become skittish and are willing to pay higher premiums for index puts to hedge portfolios. However, the trend in May was quite the opposite of fear. As you can see in figure 1, after the brief blip mid-month, VIX is once again probing the lower end of the 2016 range.

CBOE Volatility Index

FIGURE 1: VIX DIPS TO LOWS OF THE YEAR.

After a brief uptick in mid-May, the volatility index is probing the lower end of the 2016 range. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Volatility of Volatility Shows Declining Volatility

Leave it to the CBOE to create an index that tracks the volatility of volatility. That’s exactly what they did with VVIX. This index is a measure of the implied volatility priced into VIX options and, as you can see in figure 2, tends to tick higher with VIX itself. However, at the end of May, the volatility of volatility index fell back toward lows last seen about one year ago. When it (and VIX) begins showing signs of life again, it could be a sign that investors are growing more cautious and expect volatility to rise.

Volatility of volatility (VVIX)

FIGURE 2: VOLATILITY OF VOLATILITY.

The volatility of VIX options is near 52-week lows. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Bubbling Crude Oil

Crude oil prices have been an important catalyst for the broader stock market because the recent rally seems to be giving a lift to many of the companies that drill, explore, and produce the stuff. The energy component of the S&P 500 has gained nearly 30% over the past four months. Meanwhile, the volatility index for crude oil, which you can track with the ticker OVX, has dropped from higher than 81 in early February to fresh 52-week lows of 36.56 in late May. Simply put, an uptick in the OVX could be a sign that the recent optimism for the energy sector is running out of gas.

Bad Breadth in Small Caps

Lastly, and importantly, small cap stocks have not kept pace with their large-cap counterparts in the past 12 months. For instance, while the S&P 500 is down less than a percent from a year ago, the Russell 2000 Small Cap Index (RUT) is off 8%. Some market watchers think that lagging small caps can be a sign of poor market “breadth” or internals. Moreover, if small caps begin to falter again, it could be an early indication that volatility is picking up across the equities market. Therefore, it makes sense to watch not just the Russell 2000, but also RVX, which is the VIX-like index tracking options premiums for the RUT. 

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RED Option Strategy of the Week: Verticals

TJ Neil, Sr. Specialist, RED Option

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

There’s been a dramatic pullback from volatility levels seen earlier this year, but there are still potential opportunities for options traders with an idea of which way an underlying might move. One options strategy that enables options traders to participate in directional moves is a vertical spread. Verticals are one of the building blocks of risk-defined trading, and can be a logical next step for those with experience trading calls, puts, and covered calls.

There are different types of vertical spreads, but the mechanics of these trades are similar. A call vertical, for example, involves simultaneously buying one call option and selling another call option at a different strike price in the same underlying, with the same expiration. Similarly, a put vertical involves simultaneously buying a put option and selling another put option at a different strike price in the same underlying, with the same expiration.

Among call and put vertical spreads, there are two types: credit and debit. To create a credit spread, traders sell an option with a high premium and buy an option with a low premium. To form a debit spread, traders purchase a high premium option and sell an option with a low premium.

Going Vertical: Credit Spread

The risk in a vertical credit spread is determined by the difference between its strikes minus the credit received, plus transaction costs. The maximum potential profit, minus transaction costs, for a vertical credit spread is the premium collected when selling the spread. For example, if a trader sells an XYZ 102/104 call vertical for $0.60, the risk is $140 per contract and the maximum potential profit is $60 per contract, minus transaction costs. Here’s a summary of these characteristics, which you can visualize in figure 3. 

Vertical credit spread characteristics
  • Risk per contract = (spread – credit received) x 100, plus transaction costs
  • Max profit per contract = credit received x 100, minus transaction costs

For the XYZ example:

  • Risk = $140, or ($2.00 – $0.60) x 100, plus transaction costs
  • Max potential profit = $60 ($0.60 x 100), minus transaction costs
Vertical credit spread profit/loss graph

FIGURE 3: VERTICAL CREDIT SPREAD PROFIT AND LOSS.

This profit and loss graph shows max loss, breakeven, and max profit for a XYZ 102/104 credit spread. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Going Vertical: Debit Spread

When buying a vertical debit spread, the risk is the premium a trader pays for the spread. The maximum profit is determined by subtracting the premium paid for the spread from the spread between strike prices, minus transaction costs. For example, if a trader buys a FAHN 210/207 put vertical for $1.20, the risk is $120 per contract plus transaction costs and the maximum potential profit is $180, minus transaction costs.

Vertical debit spread characteristics

  • Risk per contract = the amount paid for the spread x 100, plus transaction costs
  • Max profit per contract = (spread – amount paid for spread) x 100, minus transaction costs

For the FAHN example:

  • Risk = $120 ($1.20 x 100), plus transaction costs
  • Max potential profit = $180, or ($3.00 – $1.20) x 100, minus transaction costs
Vertical debit spread profit/loss graph

FIGURE 4: VERTICAL DEBIT SPREAD PROFIT AND LOSS.

This profit and loss graph shows max loss, breakeven, and max profit for a FAHN 210/207 debit spread. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

You might have noticed the profit and loss graphs for the credit and debit spread examples are similar. This is because they are both bearish, risk-defined spreads. 

Now that you understand the basic characteristics of vertical spreads, let’s talk about their versatility. The vertical spread is a directional play that enables an options trader to express a bullish or bearish view. It can also be used to take advantage of relatively high or low volatility levels.

Let’s say an options trader thinks a stock is oversold and volatility levels are due to decrease. In this case, selling an OTM (out-of-the-money) vertical put credit spread might be appropriate. Selling a vertical put credit spread is a bullish strategy, which potentially profits from a rise in the underlying as well as a decrease in volatility.

On the other hand, let’s say an options trader believes a stock is overbought, has low volatility, and low premiums in the options. This might be a time to buy an ATM (at-the-money) vertical put debit spread. This is a bearish strategy that could profit from a fall in the underlying as well as an increase in volatility.

These are just a few of the ways that vertical spreads can be used to place directional trades on an underlying stock in a risk-defined manner. Next time you believe an underlying is poised to make a move, consider using a vertical spread to potentially capitalize on your idea.

Spreads 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.