[Option prices discussed in this article don’t include transaction costs.]
When is volatility scary? When it’s high, most investors say. High “vol” in the form of large price swings can also make account values swing quickly from profit to loss and back again. Not a lot of fun for your average investor. But ask a professional options trader, and you might get a different answer.
Less market uncertainty can push vol lower. Which means there’s less value in options as a speculative or hedging product. And this means less premium to collect for shorting them, shorting being the approach many options traders use. A lot of short strategies carry higher probabilities than their long strategy brethren. So to an options pro, the credit from shorting options can mean primary income. When vol is low, income is low—which is never fun.
Rather than bemoan low vol in an underlying’s options, traders often look for vol elsewhere, using something called “vol dispersion.” Essentially, why wait for vol to come to you? Vol dispersion is high-level stuff. It can have high capital requirements and carry risk. Vol dispersion is used in the main by trading institutions, but don’t be discouraged. You can leverage the strategy in any size account with your own defined-risk strategies.
Exploring Volatility: The Gray Area
Volatility is a metric that estimates how big a future percent change in an underlying’s price might be. But let’s look at vol differently. If you buy 100 shares of XYZ, and someone else buys 100 XYZ shares, the profit or loss as the price of XYZ shares moves and XYZ’s vol is the same for both traders.
Why? Because it’s the same stock and the same company, no matter who owns it. But what if you buy 100 shares of XYZ, and the other trader buys 100 shares of XYZ’s competitor? Maybe XYZ and the competitor have similar business models. If the prices of XYZ stock and the competitor correlate, then it’s right to expect their price vol, and implied-options vol, to be similar, too.
Now, vol between two stocks or indices are never going to be exactly the same, no matter how similar superficially. Yes, XYZ and the competitor are similar. But not identical. It’s that “almost but not quite” quality that’s at the heart of vol dispersion. When two correlated stocks are similar in price vol, and the implied-options volatilities are different, vol dispersion may be the right strategy.
Bench-marked Indexes: Just Say Yes
In practice, institutions that are long a diverse portfolio often apply vol dispersion to a benchmark index, vs. the index’s component stocks. Consider a portfolio benchmarked to hypothetical index NSX.
Suppose NSX’s largest component, MNKY, was over 13% of NSX’s total market cap. MNKY and NSX have roughly 90% correlation based on a rolling 30 days of percentage- price changes. What this means is when MNKY moves up or down, most of the time NSX moves up or down along with it, too. So, MNKY is a stock that makes up a large percent of the index, and is highly correlated to it. But MNKY’s overall implied vol is about 27%, while NSX’s overall implied vol is about 16%.
If the institution wanted to sell calls against its book, a simple example of vol dispersion would be to sell MNKY calls instead of NSX calls. MNKY calls have a relatively higher premium due to higher implied vol.
There’s more. An index of 100 stocks is often less volatile than a single stock because the index has less unsystematic risk—risk associated with a company’s management, financials, etc. So NSX has lower implied vol than MNKY for good reason. But what if you add FAHN and UBSW to MNKY? The market cap of those three comprises about 25% of NSX’s total market cap. FAHN and UBSW have relatively high correlations to the NSX, like MNKY. FAHN’s vol at 21% and UBSW’s vol at 26% are also higher than the NSX’s implied vol.
Creating, then, a mini-basket of MNKY, FAHN, and UBSW theoretically can reduce some of the unsystematic risk. Using vol dispersion, institutions might sell MNKY, FAHN, and UBSW calls with implied vols over 20%, rather than NSX calls. The institution is collecting a higher premium selling the calls in individual stocks, while the mini-basket has a high portfolio correlation. (Though, the company is also paying transaction costs for three options trades, rather than one.)
Small Profits Add Up
How much more premium might vol dispersion deliver? Let’s say, hypothetically, that selling an NSX call that’s 3% out of the money with 45 days to expiration might generate about $5,700 in premium. Selling OTM calls in MNKY, FAHN, and UBSW in quantities to match the exposure of one NSX call might generate about $12,000 in premium. With the NSX at $4,090, the value of the index is $409,000. Selling one NSX call covers about $409,000 of underlying value.
If we created an equally weighted portfolio of MNKY, FAHN, and UBSW that’s worth $409,000, that’s about 1,200 shares of MNKY at $107; 3,000 shares of FAHN at $45; and 3,800 shares of UBSW at $35.50. Selling 12 calls in MNKY, 30 calls in FAHN, and 38 calls in UBSW would be roughly the same risk exposure as one NSX call. And the credits from selling the calls in MNKY, FAHN, and UBSW generate that $12,000. Maybe that extra $6,300 from vol dispersion doesn’t sound like much in a $409,000 portfolio. But that 1.5% could set you apart.
Fear Not the Great Unkown
If returns are so great, why doesn’t everyone use vol dispersion?
First, the correlation between stocks and indices can fall. So in our example, MNKY, FAHN, and UBSW could rally and the NSX could drop, and both the short calls and the underlying book could lose money.
Second, vol dispersion can cap potential profits of the underlying portfolio just like a covered call, and provide limited crash protection.
Third, vol dispersion can be capital intensive because short calls in MNKY, FAHN, and UBSW could be considered naked, uncovered by a long-stock portfolio.
Options traders can get creative and build out diverse strategies based on relative vol differentials. If that’s not you, how can you benefit?
1/ Sell Call Verticals. For smaller accounts,short call verticals in single stocks can have lower capital requirements than naked short calls, are IRA-friendly, and can have less risk if correlations break down.
2/ Use Portfolio Margin. If you have a TD Ameritrade portfolio margin (PM) account and a diverse portfolio against which you sell index calls, you may want to consider vol dispersion. You’d sell options in those stocks that correlate to your portfolio but have higher implied vol. The PM requirements for naked short options are generally lower than a regular margin account.
Sometimes you have to dig for new opportunities when volatility is low. But vol dispersion is one way to lead with the soldiers when the generals are tired.