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Volatility Watch: Like a Spring, So Goes Market Volatility

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October 1, 2011
stock market volatility
Fredrik Broden

Now you see it, now you don’t. In early summer 2011, market volatility (measured by CBOE’s VIX volatility index) stubbornly persisted under 20% until July of the same year, when it finally broke out. By August, it spiked as high as 48%. Could you have known what expected future volatility was when the VIX was only about 16% in early July? Well, using VIX option prices to estimate the market’s expectation of its future value, at that time, the October VIX was at 22%, the November VIX was at 22.8%, and December was at 23%—indicating a possibility of higher future implied volatility.

Going Vertical

One strategy with positive vega is the long at-the-money vertical spread. When volatility is lower, the extrinsic (time) value of the first in-the-money option is lower, too. Creating long vertical spreadsby buying that first in-the-money option and selling an out-of-the-money option one or two strikes awaycan have a debit that is less than the intrinsic value of the long option at expiration. What does that mean?

Look at the intrinsic (real) value of the option that is one strike in-the-money. Now compare it to the price of the option, which is the sum of the intrinsic and extrinsic value. If you can sell the out-of-the money option for close to the extrinsic value of the long option, then you are establishing the long vertical for close to the intrinsic value of the long option. That means that if the stock stays right where it is, the spread won’t lose much money. It’s harder to establish long at-the-money verticals at these prices during periods of higher volatility.

When Vol Keeps Falling

The question is, when volatility is low, and you establish a position that has positive vega, aren’t you at risk if volatility falls? Sure. But how much risk is there that the VIX would fall from 16% to, say, 12%, and how great a loss would that create for a long vega position? For example, if the vega in a two-month vertical spread in S&P 500 options is + 0.10, that means a long vertical spread worth, say, 2.00 with volatility at 16% today could drop to 1.60 if volatility drops to 12%.

In ten years, the VIX has not dropped below 9%, and it has rarely dropped below 14% (source: thinkorswim™ Charts).

Volatility is often low during the summer months, only to historically rise in the fall. While there is risk in a long vega position if the VIX goes from 16% to 14%, it’s not as great as when volatility is 30% and drops to 20%.

With Vol all over the map this year, who knows where it will be by the time you read this. But when the VIX eventually comes down from its perch, and you believe that there is support for the VIX at a certain level (look at your charts), you could use dips in volatility to establish long vega positions. again, Keep in mind that an increase in implied volatility does not have to be accompanied by an increase in the magnitude of percentage price changes in an index or stock. That’s one reason to avoid possibly just buying calls and puts, even though they would have positive vega.