Sudden spikes in the CBOE Volatility Index (VIX) are sometimes associated with changes in investor sentiment. After all, the index has been dubbed the market’s "fear gauge" for a reason. This is because the VIX tends to move higher during periods of market turmoil and uncertainty, or times when the premiums for S&P 500 Index (SPX) options become more expensive due to increased demand for portfolio protection. This was the case last week when the S&P 500 suffered a steady series of losses amid a variety of global economic anxieties. Yet, so far, actual volatility remains relatively low, and this has created a disconnect between VIX and measures of the market’s actual levels of market volatility. Let’s take a look at the numbers.
VIX Breaks Out from Tight Trading Range
After spending several months in a range between roughly 13 and 17, the VIX gathered some upside momentum last week. As you can see in figure 1, the VIX moved above the 20 level for the first time since February. It moved as high as 22.89 midday Thursday. At this level, the VIX had gained nearly 10 points, or 70%, in a little more than a week!
VIX was not the only volatility index on the move last week. The table below shows the year-to-date and June performances for a number of implied volatility indexes (through June 16, 2016). While VIX is up 36.5% for the month, NASDAQ 100 vol (VXN) and Dow Industrials volatility (VXD) are up nearly 30. Gold vol (GVZ) and euro currency volatility (EVZ) are up substantially in June, which may be a product of fears over Brexit. In fact, implied volatility seems to be moving higher across most asset classes.
|S&P 500 ||VIX||36.5%||6.4%|
Disconnect Between Implied and Realized Volatility
While VIX and other indexes that track implied volatility have been moving higher, it’s interesting to note that actual volatility remains rather low. For example, the 30-day historical volatility (HV) of the S&P 500 remains under 10% and unchanged from a week ago. Recall that VIX is a gauge of implied volatility that is computed using a pricing model and live options prices. HV is an annualized standard deviation of closing prices of the underlying index over a past number of days.
Figure 2 shows the percentage difference between VIX and the S&P 500 Index 30-day HV over the past 10 years. For instance, Thursday, 30-day HV was 9.5% and VIX was 19.37. Therefore, VIX was roughly double, or 100% greater, than the market’s actual volatility over the past 30 days.
While VIX typically remains above the 30-day HV of the S&P 500 (the chart in figure 2 is usually above zero), extreme differences like the spike observed last week are typically short-lived. The last spike was in August 2015 and the one before that in December 2014.
History shows that, after these wide disconnects, implied volatility begins to ease, or actual volatility moves higher, or a combination of the two. There’s never a way to predict which of these scenarios will happen next. So, it’s anybody’s guess this time around. The thing we do know is that sentiment saw a notable shift that pushed VIX above 20 and that, in turn, suggested that options premiums suddenly became quite rich (relative to actual volatility) across a number of different asset classes.
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RED Option Strategy of the Week: Iron Condors
T. J. Neil, Sr. Specialist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
After a period of slumping volatility, the markets are beginning to reflect the current uncertainty in the world. Investors are pondering the rate decisions of the Federal Reserve, Bank of Japan, and Bank of England.
Then there’s the looming Brexit (British exit from the EU) vote on June 23. Global investors have shown an aversion to risk and an insatiable appetite for government bonds. So much so, that they’re willing to park money in bonds with negative interest rates.
Meanwhile, the VIX has almost doubled in a span of just two weeks. With this rise in volatility, it’s time to talk about a risk-defined strategy that is designed to capitalize on elevated volatility levels in a range-bound market: the short iron condor.
A short iron condor is a four-legged spread constructed by selling one call vertical spread and one put vertical spread simultaneously, in the same expiration cycle. Typically, both vertical spreads are out-of-the-money and centered around the current underlying price. Similar to a single vertical spread, the risk is determined by the distance between the strikes of the vertical.
For example, if the vertical spread is $2 wide, the risk would be $200 per contract, minus the credit received for selling the iron condor, plus transaction costs. In the best-case scenario, the underlying stays between the two short strikes through expiration, and both vertical spreads expire worthless. This would allow a trader to keep the full credit that the iron condor was sold for, minus transaction costs.
Let’s look at an example. Suppose a trader would like to place a neutral short iron condor on XYZ trading at $52.50. To create the position, the trader could sell a 47.5 put and buy a 45 put and a sell a 55 call and buy a 57.5 call for a combined credit of $0.70. This would give the trader a $10 range, between the put with a low strike at 45 and call with a high strike at 55, in which the trade could achieve its maximum profit potential. The position would have an upside breakeven level of $55.70 and a downside breakeven level of $46.80, as shown in figure 3. If the stock remains between the short $47.5 and $55 strikes through expiration, the maximum potential profit would be $70 per contract, minus transaction costs, and is the credit received when initiating the position. The maximum potential loss would be $180 per contract plus transaction costs.
When volatility levels are elevated, so are the credits that can be collected when selling an iron condor. Any increase in volatility typically expands an option’s premium, which inflates prices of the individual vertical spreads.
And remember the short iron condor is a neutral strategy when centered around the current underlying price, but it can be made bullish or bearish by skewing it toward either of the verticals.
The short iron condor is a potential strategy to implement in times of uncertainty. It allows a trader to create a position that takes advantage of excessive risk premium in a risk-defined manner. By taking this position, a trader is making two basic assumptions: current volatility is elevated and believes it will decrease at some point before the position expires; and the underlying will remain between the two short strikes of the iron condor through expiration. The key is to understand that fear-driven markets all come to an end eventually, and a short iron condor can be used when a trader feels fear is about to subside.
Spreads, iron condors 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.