What a difference a few weeks can make! In late June, the CBOE Volatility Index (VIX) rallied to the mid-20s and its best levels in months. Indeed, the market’s “fear gauge” had been ticking higher leading up to the U.K. referendum on June 23 and then continued its move through two days of heavy selling in the stock market beginning June 24. However, June 27 proved to be a turning point, and VIX has been falling in steady fashion since. In addition, in sharp contrast to the situation a few weeks ago, the volatility index is now low relative to the actual volatility of the S&P 500. Let’s review what happened.
VIX Slumps as Stocks Rally
After a notable spike in mid-February, VIX slipped into a downtrend and then remained in a multi-month range between roughly 13 and 17 in the months that followed. It started the gradual climb into mid-June before the spike when the U.K. voted to leave the European Union, which rattled global markets on June 24. Since that time, as you can see in figure 1, VIX has given back all of the June gains and, at less than 13, is near 2016 lows.
VIX ended June at 15.36 and more than 10 points from the June 27 peak levels. In addition, as you can see in the table below, the index, which tracks the expected or implied volatility priced into a strip of short-term options on the S&P 500 Index (SPX), has lost another 16.5% through the first two weeks of July.
|Volatility Index||Symbol||Month to Date %|
|Russell Small Cap||RVX||-15.2%|
Data source: CBOE
VIX isn’t alone. Other measures of volatility for the stock market, such as the Dow Jones Industrial Average (VXD) and Russell Small Cap (RVX), are down sharply as well. In other markets, such as Treasury bonds (TYVIX) and crude oil (OVX), the implied volatility indexes paint a mixed picture. Overall, however, the general trend has been for a move lower across most markets through the first half of July. And these declines come after substantial declines in the final days of June.
How Long Can VIX Go?
The recent slide in VIX is interesting for more than one reason. Obviously, a decline from the mid-20s to the low teens in a few weeks is a large move. In addition, overall levels of actual or real volatility seem somewhat elevated in mid-July.
In fact, less than a month ago, I noted that the difference between VIX and the actual volatility of the S&P 500 had become quite high. That’s because the market had been trading quietly for several months, but the volatility index had experienced a notable increase. At an extreme, VIX was north of 21 on June 22 and 30-day actual volatility or historical volatility (which is computed using closing prices of the S&P 500) was less than 10%. That is, VIX was 122% greater than real volatility, and that large difference can be seen as the last spike higher in figure 2.
Since late June, not only has VIX dropped below 13, but the relationship between the volatility index and real volatility has shifted to the opposite extreme. Specifically, with VIX below 13 and the 30-day HV of the S&P 500 at 16.5, the volatility index is 21% below real volatility and, as you can see from the chart, this difference is now quite extreme. In fact, it is the lowest level since October 2015.
VIX tends to be above SPX historical volatility more often than not. When the difference becomes very negative, as is the case now, it tends to revert back to the mean. That is, either (1) VIX is correct in anticipating a drop in real volatility and the market begins to trade quietly, meaning historical volatility declines, or (2) the volatility index begins to move higher to better reflect the market’s actual volatility. Of course, a combination of the two scenarios is also possible.
The point to take home, from a volatility perspective, is there is a chance that VIX is getting ahead of itself because, while VIX is at 2016 lows, actual market volatility today is quite a bit higher than it was just a few weeks ago.
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Red Option Strategy of the Week: Long Vertical Spread
T.J. Neil, Sr. Specialist, RED Option Advisors
Editor's Note: As of October 3, 2016, RED Option is now Trade Wise.
Like Fred noted above, a lot has changed in the last few weeks on the volatility front. Less than a month ago we saw volatility levels jump, leading up to and following the unexpected Brexit vote results. Then we had the largest 3 week drop in the VIX (CBOE S&P 500 Volatility Index) ever. With the S&P 500 near all-time highs and volatility levels much lower, it might be a good time to look at a directional strategy that seeks to take advantage of lowered volatility: the Long Vertical Spread.
Just in case you are new to vertical spreads, let’s go over some basics. There are different types of vertical spreads, but the mechanics are similar from one type to the next. 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, in the same expiration cycle. Similarly, a put vertical involves simultaneously buying a put option and selling another put option at a different strike price in the same underlying, in the same expiration cycle.
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.
When buying a vertical debit spread, the risk is limited to whatever a trader pays for the spread. The maximum potential profit is determined by subtracting the premium paid for the spread from the width of the spread. For example, if a trader buys a XYZ 197/194 put vertical for $1.20, the risk is $120 per contract (plus transaction costs) and the maximum potential profit is $180 per contract (minus transaction costs). Since this is a debit spread, a trader would buy the 197 put and sell the 194 put.
Vertical Debit Spread Characteristics
- Risk per contract = the amount paid for the spread x 100, plus transaction costs
- Max profit per contract = (width of spread – amount paid for spread) x 100, minus transaction costs
For the XYZ example:
- Risk = $120 ($1.20 x 100), plus transaction costs
- Max potential profit = $180, or ($3.00 – $1.20) x 100, minus transaction costs
Now that we have gone over the basic characteristics of vertical spreads, let’s talk about the long vertical spread. The long vertical spread is a directional play that allows a trader to be bullish or bearish based on the way the spread is executed. Because a trader is looking to buy an at-the-money (ATM) call or put when buying a debit vertical spread, this strategy can also be used to capitalize on lowered volatility levels. Options that are ATM are the most sensitive to changes in volatility, so any increase in the implied volatility will help increase the value of the spread.
Let’s say a trader believes that a stock is ready to breakout of a tight trading range and make a move higher. In this case, purchasing an ATM vertical call debit spread might be appropriate. Buying a vertical call debit spread is a bullish strategy, which seeks to profit from an increase in volatility.
On the other hand, what if a trader believes a stock is overbought, has relatively low implied volatility, and lowered option premiums? This might be a good time to buy an ATM vertical put debit spread. This is a bearish strategy that seeks to profit from an increase in volatility.
Another aspect of long verticals that can be appealing is leverage. This can play out because your risk is only what you pay for the spread and your maximum profit potential is determined by the width of the spread (as explained earlier). This dynamic allows for some advantageous risk/reward ratios.
Low volatility environments do not last forever. So, if you’re looking at an underlying that is poised to make a move, think about using a long vertical spread to capitalize on your idea.