The U.S. stock market ended the second quarter in dramatic fashion after the S&P 500 (SPX) staged an impressive three-day rally amounting to about 4.9%. The rebound in stocks erased almost all of the two-day swoon from June 24 to 27, when the SPX lost 5.4% in the wake of the U.K.’s decision to leave the European Union, also known as Brexit. The wild ups and downs left the SPX almost unchanged for June and roughly 2% higher for the quarter. For the year, the index is up a modest 2.7% and now, with the second half underway, risk perceptions across the stock market seem a bit higher compared to the sentiment at the end of the first quarter.
Volatility Slips as Stocks Rally
The CBOE Volatility Index (VIX) had its fair share of ups and downs in the first half of 2016. VIX started the year moving higher and hit its highest level of the year at 32.09 on January 20. As you can see in figure 1, a second VIX spike developed into early February. From there, the index fell into a downtrend, then remained in a tight multi-month range between about 13 and 17.
More recently, however, the market’s “fear gauge” moved higher through mid-June and saw another large spike to multimonth highs, reaching up to about 25. From that point forward, VIX suffered a four-day drop of nearly 40%! Interestingly, VIX finished the month smack dab in the middle of its previous multimonth range between 13 and 17.
For the second quarter, VIX was up from 13.95, or 10.1%. It remains down 15.7% year to date, however, thanks to the large 23.4% decline seen in the first few months of the year. That’s true of many of the VIX-like indexes that track implied volatility for different assets. For instance, while volatility of the Dow rose 10.3% over the past few months, it’s down 10.9% for the year.
Interestingly, some international markets (Brazil and China) seemed to have experienced declines in implied volatility during the second quarter. Crude oil volatility, as measured by OVX, fell as well.
Uptick in VIX and SPX?
The 10.1% uptick in VIX occurred as the S&P 500 added 1.9% during the second quarter. The typical pattern is for the volatility index to move opposite the trend in the stock market. That’s because VIX tracks the implied volatility in a strip of short-term SPX options and therefore tends to increase in value when risk perceptions are rising.
In the second quarter, however, VIX moved higher, even as nearly every sector of the market strengthened. Only technology and consumer discretionary sectors ticked lower over the past three months. Therefore, it appears that VIX didn’t follow its normal trend of moving lower as stocks generally moved higher.
Yet, an uptick in VIX to 15.63 from 13.95 is not a massive move given that it ended March at relatively low levels. In addition, it’s well off the high of 25 seen on June 24. Nevertheless, the rise in VIX and other VIX-like indexes during the second quarter suggests, perhaps, that market participants are “pricing in” the prospect for a bit more market volatility as we look out over the remainder of the year. This includes two more corporate earnings seasons, several Fed meetings, and, of course, the upcoming U.S. presidential elections.
Free: 2 Strategies for 2 Months*
Get step-by-step TradeWise trade ideas from former floor traders delivered directly to your inbox. At checkout, enter coupon code "ticker".
RED Option Strategy of the Week: Covered Call
T.J. Neil, Sr. Specialist, RED Option
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
In response to the recent unexpected Brexit vote results, global markets moved sharply lower and at one point the S&P 500 was close to 6% off the recent highs. The uncertainty has been reflected through increased market volatility and expanding option premiums. As conditions begin to stabilize, it might be time to begin thinking about adding some long-term positions in stocks or selling a call option against an existing position.
A strategy that seeks to take advantage of elevated volatility levels is the covered call. For those who have established stock positions, the strategy can be replicated by selling calls on the same stock.
Creating a covered call position from scratch, also known as a “buy-write,” involves selling one call option and purchasing 100 shares of stock simultaneously. The short call is “covered” because it’s hedged by 100 shares of stock. Under most circumstances, 1 call option contract controls 100 shares of stock simultaneously.
Equity call options give the owner the right but not the obligation to exercise their option and purchase 100 shares of stock at the strike price at any time prior to expiration. If the long call holder decides to exercise, a short call is “covered” by long stock, which can be delivered to the exerciser.
Selling or “writing” calls against a long stock position generates income in the form of the premium received, minus transaction costs. This income has the potential to enhance the overall return of a stock purchase while lowering its breakeven price.
Let’s take a look at an example of how a call writing strategy could be implemented to enhance an existing stock position.
Let’s say you previously purchased 100 shares of XYZ stock for $40.00 per share and the shares are now trading at $42.00. The position has worked out well, but you believe the stock will have limited upside in the near term. If this is the case, you could sell 1, out-of-the-money, Aug 45 strike call for $0.66, and collect $66 (minus transaction costs).
A risk that needs to be considered is that XYZ stock could make a move above $45 prior to the August expiration date, when your short call expires. If this were to happen, the chances the stock could be called away early would increase. If the stock closed $0.01, or more, above $45 on the last trading day in August, prior to expiration, the short call would likely go through automatic assignment and the stock would be called away and sold at the $45 strike price.
Although with this strategy the gains in the stock are capped if the stock price rises above the $45 strike price prior to or at expiration, this would still result in the strategy being profitable. The difference being, if the stock is called away, you would not participate in further appreciation above the strike price.
As long as the stock price stays below the $45 strike through the August expiration, the call will expire worthless and you’ll keep the $0.66 premium, minus transaction costs. In addition, the August expiration approaches (with the stock price at or near the strike price), the short call position could be “rolled” to a later expiration cycle for another credit. This could be done by buying back the 1 short Aug 45 call and selling a different 45 strike call, in a further out expiration month. The result is the trade being extended while generating additional income through rolling the call for a credit.
The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received.
Rolling strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.