There’s more than one way to skin a cat. That familiar (and somewhat troubling) adage is used when somebody wants to say that there’s more than one way to do something. I think it’s apropos for this period in the markets, and I want to point out that there’s more than one way to look at, and trade, this market, especially when it comes to volatility. One unique tool I’ll highlight in this article is called Average True Range, which has produced some interesting readings lately.
Market Volatility: Flatlining, But for How Long?
Sticking with the cat theme, another expression (used mostly only on Wall Street) is dead cat bounce. Traders utter this phrase when a stock or some other security makes a temporary recovery after a prolonged bear market. In terms of volatility, there have been no bounces at all this week—not a live cat, dead cat, skinned cat, furry cat, or any type of cat-bounce at all. What is going on?
As you can see in figure 1, the CBOE Volatility Index (VIX) fell sharply after the late June spike around the Brexit decision. By mid-July, the “fear gauge” was below 12 and, as the S&P 500 (SPX) has been setting record highs, VIX has been chopping around somewhat aimlessly, mostly between 11 and 13, for the past month. Since VIX tracks the expected or implied volatility priced into a strip of short-term options on the SPX, it’s not unusual to see it tick lower when the broader market grinds higher. That has been the textbook case in recent weeks.
True Range: Looking Beyond the Options Market at Volatility
Low VIX reflects not just the recent decline in implied volatility across SPX options, but also the market’s underlying tone. Consider this: the average daily range (difference between a day’s high and low) in the SPX over the past month (through August 18) is just 6.10 points. In almost half of the trading sessions since mid-July, it’s moved less than 4 points!
In other words, realized volatility is at extreme lows, and we can confirm this using the Average True Range (ATR) indicator. Developed by J. Welles Wilder and featured in his 1978 book New Concepts in Technical Trading Systems, ATR is a measure of actual volatility (as is the historical volatility discussed last week), but also considers potential gap moves that can occur from one day to the next, especially in some of the commodities markets. (A “gap” happens when the price of a security opens sharply higher or lower compared to the previous day’s close.)
Specifically, the true range is the greatest of either:
- The high of the day minus the low
- The high minus the previous close, or
- The day’s low minus the previous close
Going one step further, the ATR is a formula based on true ranges over time, with 14 days being a common default setting. Fortunately, we don’t need to compute the numbers by hand, because many trading platforms, including the TD Ameritrade thinkorswim® platform, provide the indicator as part of their charting packages. Take a look at figure 2 as an example. It’s a three-year daily chart of the SPX. Do you see how ATR is heading lower while the SPX grinds higher?
In fact, at 13.4, ATR is at its lowest levels since September 2014. This means the volatility of the stock market as measured not just by VIX, but using a range of prices, is at historically low levels. Does this mean it’s likely to move higher? History suggests the answer is yes, but the outcome will ultimately be driven by prevailing investor sentiment. And, at the end of the day, the actions of humans can be quite unpredictable.
Don’t believe me? Ask a cat.
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Verticals: The Versatile Spread
T.J. Neil, Sr. Specialist, RED Option
Earnings season is wrapping up, and volatility levels are low, but there are still potential opportunities for options traders with an idea of which way an underlying might move. One options strategy designed to take advantage of directional moves is a vertical spread. Verticals are one of the building blocks of risk-defined trading, and can be a logical next step for those with experience trading long calls, long puts, and writing covered calls.
There are different types of vertical spreads, but the mechanics of these trades are similar. 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, with the same expiration. Similarly, a put vertical involves simultaneously buying a put option and selling another put option at a different strike price in the same underlying, with the same expiration.
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.
The Credit Spread
The risk in a vertical credit spread is determined by the difference between its strikes minus the credit received, plus transaction costs. The maximum potential profit for a vertical credit spread is the premium collected when selling the spread, minus transaction costs. For example, if a trader sells an XYZ 102/104 call vertical for $0.60, the risk is $140 per contract and the maximum potential profit is $60 per contract, minus transaction costs.
Here’s a summary of these characteristics, which you can visualize in figure 3.
Vertical credit spread characteristics
· Risk per contract = (spread – credit received) x 100, plus transaction costs
· Max profit per contract = credit received x 100, minus transaction costs
For the XYZ example:
· Risk = $140, or ($2.00 – $0.60) x 100, plus transaction costs
· Breakeven level = $102.60, or $102 (the short strike) + $0.60 (credit received)
· Max potential profit = $60 ($0.60 x 100), minus transaction costs
The Debit Spread
When buying a vertical debit spread, the risk is the premium a trader pays for the spread. The maximum profit is determined by subtracting the premium paid for the spread from the spread between strike prices, minus transaction costs. For example, if a trader buys a FAHN 210/207 put vertical for $1.20, the risk is $120 per contract plus transaction costs and the maximum potential profit is $180, minus transaction costs.
Here’s a summary of these characteristics, which you can visualize in figure 4.
Vertical debit spread characteristics
· Risk per contract = the amount paid for the spread x 100, plus transaction costs
· Max profit per contract = (spread – amount paid for spread) x 100, minus transaction costs
For the FAHN example:
· Risk = $120 ($1.20 x 100), plus transaction costs
· Breakeven level = $208.80, $210 (long strike) - $1.20 (the debit paid for the spread)
· Max potential profit = $180, or ($3.00 – $1.20) x 100, minus transaction costs
You might have noticed the profit and loss graphs for the call credit spread and the put debit spread examples are similar. This is because they are both bearish, risk-defined spreads.
Now that you understand the basic characteristics of vertical spreads, let’s talk about their versatility. The vertical spread is a directional play that enables an options trader to express a bullish or bearish view. It can also be used to take advantage of relatively high or low volatility levels.
Let’s say an options trader thinks a stock is oversold and volatility levels are due to decrease. In this case, selling an out-of-the-money vertical put credit spread might be appropriate. Selling a vertical put credit spread is a bullish strategy, which seeks to profit from a rise in the price of the underlying as well as a decrease in volatility.
On the other hand, let’s say an options trader believes a stock is overbought, has low volatility, and low premiums in the options. This might be a time to buy an at-the-money vertical put debit spread. This is a bearish strategy that seeks to profit from a fall in the price of the underlying as well as an increase in volatility.
These are just a few of the ways that vertical spreads can be used to place directional trades on an underlying stock in a risk-defined manner. Next time you believe an underlying is poised to make a move, consider using a vertical spread to potentially capitalize on your idea.