The CBOE Volatility Index (VIX) notched 2016 lows last week after falling below 12 for the first time since August 2015. The market’s so-called “fear gauge” is now a far cry, or roughly half the levels, from late June when it was trading in the mid-20s. The sharp decline in the index seems to reflect a notable change in sentiment and comes as investor focus appears to have shifted to second-quarter earnings and away from the macro concerns that roiled financial markets a month ago. The change in sentiment has been reflected with notable shifts along the VIX “curve” as well.
VIX Probes New Lows for the Year
Few market watchers would have probably predicted last month that VIX would be below 12 in July. Recall that the index saw a spike on June 24 after the U.K. referendum produced a somewhat unexpected outcome, and this uncertainty created heavy selling across global equities markets. And as the S&P 500 tumbled 5.2% from June 24 to June 27, VIX took a stab at multi-month highs of 27, as seen in figure 1.
You can see in figure 1 how VIX has settled down quite a bit since the Brexit vote. The index fell sharply in the final days of June and has been trending lower in July. Now it's not only substantially below June highs, but also well below the multi-month trading range of roughly 13 to 17 seen before the June spike.
VIX Structure: Not So Simple Terms
VIX below 12 suggests that some of the options premiums on the S&P 500 index are at relatively low levels. However, the volatility index captures only the implied volatility of very short-term SPX options. That’s one reason why it’s so jumpy during times of market uncertainty; it’s the shorter-term options that typically see the greatest changes in implied volatility from one day to the next.
Figure 2 shows the VIX "term structure" that the Chicago Board Options Exchange (CBOE) updates throughout the day. The snapshot was taken on July 21 as the volatility index hovered around 12. It shows SPX implied volatility, using the VIX methodology, for a variety of expiration months. For instance, while August is near 12, the curve is at 16 by October and it’s north of 20 by early 2017.
Now rewind one month to June 27, and the VIX curve looks much different. You can see this in figure 3, which shows that short-term volatility had jumped to more than 23. This is similar to “backwardation” in the futures market, where short-term contracts trade at higher levels compared to long-term contracts. When it happens with options on the S&P 500 Index, this flattening of the curve is typically a sign that risk perceptions are on the rise.
The term structure of VIX options today (figure 2) is not all that unusual. In fact, the VIX curve is upward sloping more often than not and periods of backwardation (figure 3) are usually short-lived. The remarkable thing to consider is, not just that VIX was cut in half in less than a month, but also how quickly the VIX curve shifted back to normal. This is just further evidence of how rapidly investor sentiment can change in today’s fast-moving financial markets.
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RED Option Strategy of the Week: Iron Condors During Earnings
T.J. Neil, Sr. Specialist, RED Option Advisors
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Just when you thought volatility levels couldn't get any lower, the VIX has slipped to fresh lows. This is occurring going into the thick of earnings season. Although overall volatility levels are low, there are individual stocks that have elevated implied volatilities due to upcoming earnings announcements.
Keep in mind, implied volatilities can be elevated for a reason. Earnings announcements are events that can bring about larger than normal moves in stocks. Because of this, option expiration cycles that encompass an earnings date can have higher implied volatilities in that cycle. If the market believes a stock might move more following an earnings announcement, that expiration cycle’s volatility level will be elevated.
The implied volatility of a particular option expiration cycle is made up of normal volatility days, plus any event (earnings) volatility days from now till those options expire. As an earnings announcement approaches, there are fewer normal volatility days and the effect of the earnings event volatility will become more pronounced.
The short iron condor is a risk-defined strategy designed to allow a trader to take advantage of elevated option premiums during earnings. Just in case you are new to iron condors, let’s go over some of the basics of the strategy.
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.
If the vertical spreads are $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 price of the underlying stays between the two short strikes through expiration, and both vertical spreads expire worthless. This allows a trader to keep the full credit that the iron condor was sold for, minus transaction costs.
Let’s look at a hypothetical example. Suppose a trader would like to create a neutral short iron condor position on XYZ, which is currently trading at $52.50. To create the position, the trader could sell a $47.5 put, buy a $45 put, 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 the 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 4. 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 (the credit received when the position was initiated). 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 the prices of the individual vertical spreads.
The short iron condor is a potential strategy to consider implementing in times of uncertainty, such as prior to earnings announcements. This strategy is designed to take advantage of inflated risk premium in a risk-defined manner. By taking this position prior to earnings, a trader is making two basic assumptions:
- Current volatility is elevated and they believe it will decrease once the earnings are released.
- The price of the underlying will remain between the two short strikes of the iron condor after the market has digested the earnings results.
The key is to understand that the market is pricing in what it feels the potential move will be, and a short iron condor can be used when a trader feels the market is overstating the potential move.