The CBOE Volatility Index (VIX) reached four-month highs late last week. As stocks across the globe faced a day of heavy selling pressure, currencies gyrated, and bond yields fell, the market’s “fear gauge” did as it typically does during times of market turmoil: it moved higher.
VIX had already moved well off the lower end of the 2016 range prior to the June 24 spike on news of the Brexit vote. Looking forward, the elevated readings from a number of VIX-like indexes suggest that market participants are bracing for additional volatility in the weeks ahead.
VIX Ticks Higher after U.K. Vote
After several months of range-bound action between roughly 13 and 17, VIX gathered some momentum through mid-June and, by June 13, had moved above the 20 level for the first time since February. As noted last week, a nearly 70% one-week climb in VIX was impressive given that the overall market seemed to be trading in rather quiet fashion from one day to the next.
Recall that VIX is computed using an options pricing model and the latest prices of a strip of short-term options on the S&P 500 Index (SPX). For that reason, VIX is often viewed as a forward-looking indicator.
The rally in VIX amid relatively low actual, or realized, volatility in the S&P 500 suggested that market participants were possibly bracing for an event or a series of events to trigger an uptick in S&P 500 volatility in the future. The Brexit vote was one of those potential catalysts, and markets were indeed jolted when British voters surprised the pundits by deciding it was time for the U.K. to leave the European Union.
As global financial markets reacted, volatility indexes moved broadly higher, and none moved more than the VIX. The table below shows June 24 implied volatility spikes across a number of different asset classes, including gold, oil, and the euro currency. VIX tops the list with a one-day gain of nearly 50%.
|CBOE Volatility Index||VIX||49.30%|
|CBOE EAFE Volatility Index||VXEFA||45.70%|
|Euro Currency Volatility||EVZ||9.20%|
|Treasury Bond Volatility||TYVIX||8.80%|
|Crude Oil Volatility||OVX||8.10%|
Volatility in Europe, Australia, and Far East
The VIX for the MSCI EAFE Index (VXEFA) was a notable mover last week as well. While VIX tracks the expected or implied volatility priced into a strip of S&P 500 Index options, VXEFA tracks the implied volatility for options on the Europe, Australia, and Far East (EAFE) index. In other words, it tracks the volatility of markets outside of North America. Therefore, taken together, VIX and VXEFA offer an interesting snapshot for risk perceptions related to global equities markets.
Like VIX, VXEFA was moving higher into mid-June. However, notice in figure 2 that it fell sharply on June 23 and before the Brexit referendum. The decline was perhaps an indication that investors were growing confident that the event would pass without a hitch. Then came the shocker, and VXEFA saw a 45% spike on June 24.
Going forward, there is no way to predict what VIX and other VIX-like indexes will do next, but the relatively high readings suggest that market participants expect volatility in the U.S. and overseas equities markets to remain elevated compared to the previous few months. This is likely due to concerns about the negative impact of recent events on the global economy and corporate earnings. Some also expect other European Union member nations to hold similar referendums and, if so, a sense of uncertainty could very well persist in the months ahead.
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RED Option Strategy of the Week: Turning a Short Option into a Risk-Defined Vertical
T.J. Neil, Sr. Specialist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Events drive volatility, and the Brexit vote is an event we won’t soon forget. There are probably more than a few traders who sold naked puts thinking that the recent rise in volatility would subside, and now they’re wishing their trade had been risk defined.
Although selling naked options can be a viable strategy, it’s definitely not for beginners. It can be very capital intensive because of the margin requirements to hold these positions. The risk of a short naked call is infinite. A short naked put’s risk is determined by how far the strike price of the underlying is from zero.
There’s a way to turn naked options into risk-defined positions and free up capital at the same time. The strategy: a vertical spread.
By definition, a call vertical spread is long one call option and short another call option at a different strike price in the same underlying, in the same expiration cycle. Similarly, a put vertical spread is long one put option and short another put option at a different strike price in the same underlying, in the same expiration cycle. Usually both legs of a vertical spread are executed simultaneously, but you can achieve the same results by buying an option that’s further out of the money than the existing short option position.
Here’s an example to illustrate. Let’s say a week ago you sold one naked Jul 67 put in XYZ stock for $1.25, and now they’re trading at $1.10. The position is working in your favor, but you would like to reduce your risk and lower the margin requirement without closing the position.
In this case, you could buy a Jul 62 put for $0.25, which would create an XYZ Jul 67/62 short put vertical for a net credit of $1. The result is a risk-defined short put vertical with a risk of $400 per contract (plus transaction costs) and a potential profit of $100 (minus transaction costs). The vertical spread has $25 less potential profit, but you have also reduced your margin requirement by a whopping $6,075 per contract!
Without full options approval (Level 3), you cannot sell naked puts, and instead must sell puts that are cash-secured, which is capital intensive. (Selling cash-secured puts requires Tier 1 option approval, or higher.) The margin on one cash-secured put is determined by multiplying the strike price of the put by $100 and subtracting the credit received. For example, if you sold one cash-secured put with a strike price of 50 for $1, you would have to put up $4,900 in margin to place the trade. That’s a large sum to tie up when the max profit potential is $100.
Naked calls can't be sold without full options approval because of their infinite risk. Stocks or other underlying assets have unlimited upside—theoretically, they could rise to infinity. This risk is transferred to short naked calls because they are unhedged.
Capital preservation is one of the cornerstones of responsible trading. By vastly reducing a margin requirement, you are making funds available for your next trading opportunity. The intensive capital requirements associated with selling naked options can even be cost-prohibitive for those with full options approval.
So the next time you are short a naked option and are looking for some extra option-buying power, think about turning your short option into a risk-defined vertical spread.