When discussing the markets, there’s a common question among investors and traders: What’s your position?
When discussing the markets, there’s a common question among investors and traders: "What’s your position?" The answer often varies based on the individual’s level of expertise.
For beginning investors, the answer is usually “I own a few stocks.” For the intermediate investor or trader, it might be “I have covered call positions or option spreads in several names.” For the advanced or professional trader, the answer might be very different and involve being “long or short volatility.” Here’s why.
Investors typically own stocks and tend to have an upward bias toward the stock market, whatever the size of their positions or portfolios. Traders, on the other hand, seek to generate profits in both directions—up and down. Traders look for opportunities where events have caused things to be temporarily “out of whack.” Traders often look to exploit this divergence from the norm and potentially profit from it. So how do traders do that? Mean reversion.
Mean reversion is the theory that, over time, something will move back or return to its average historical levels. Put another way, things usually return to normal—eventually. The problem is, stock and option prices are typically not mean reverting. For instance, a stock can go up and keep going up. It doesn’t necessarily have to move back to its average price over a specific time period.
So what do professional traders look at instead? Implied volatility (IV). The IV of options is considered mean reverting, which means that for the most part, it typically rises after it gets too low and falls after it gets too high. Traders can use this ebb and flow to establish and manage positions.
Let’s look at an example using the S&P 500 (SPX). The SPX IV over the past three years (see figure 1) shows a range of about 0.10 (10%) to about 0.29 (29%).
FIGURE 1: S&P 500 (SPX) AND IMPLIED VOLATILITY (IV).
To add IV to a chart, click Studies > Quick Study > Volatility Studies > ImpVolatility. Data source: NYSE, CBOE. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The SPX IV tends to bounce between about 15% and 20% to 25%. To be sure, there are periods of extreme volatility. Just look at the spike in the SPX IV in August 2015 and then again in early 2016. But the ebb and flow of IV usually returns to a long-term average.
Seasonal factors and events—both on the calendar and unexpected—can be factors in implied volatility trends. Spring and summer historically drag down volatility unless events drive it higher.
IV can be measured and monitored to help a trader make strategic decisions for taking long or short volatility positions. For example, when IV is at the low end of its range, an options trader might look to take advantage by buying calendar or diagonal spreads. When IV is at the high end of its range, short vertical spreads and iron condors might be worth considering.
There’s another way to look at IV for the SPX: via the CBOE Volatility Index (VIX). The VIX just happens to measure implied volatility of the SPX, similar to the SPX IV study in figure 1.
Looking at the three-year chart of VIX (see figure 2), you can see it follows the trajectory of the IV study pretty closely. The spikes tend to be higher in the VIX, but overall, the trends are similar.
FIGURE 2: CBOE MARKET VOLATILITY INDEX.
Like the SPX IV, the VIX tends to move in a range of high and low levels, returning to a long-term average. Data source: CBOE. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The VIX has grown in popularity to the extent that there are now options traded on this volatility measurement. Traders can use VIX as a macroeconomic measurement or trade options on the actual VIX level. Many professional traders use a combination of volatility data and strategy to exploit the mean-reverting aspects of volatility.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.