Stock market volatility is an important consideration in options trading. Although it does not receive much attention in the community of stock traders, it is nevertheless becoming a useful, popular indicator for many trading professionals including the money managers nowadays. There are many authoritative books on volatility in options trading. Some which are written by well-known writers such as Lawrence McMillan and Leonard Yates, my favorite writers. Hence, I would not want to repeat what these great authors had written but to focus on aspects that are practical for options trading.
Options trading in different degree of volatility will demand different approaches to counter or leverage on the volatility of the markets. In low volatility environment, we would adopt strategies that are bullish on volatility. In high volatility condition, we would take up strategies that are bearish on volatility.
Before I begin to suggest what and how to trade the current market that is low in volatility, it is perhaps helpful to understand what market volatility is and what volatility indicator we shall use to measure market volatility.
CBOE Volatility Index (VIX)
In 1993, the Chicago Board Options Exchange® (CBOE®) introduced the CBOE
Volatility Index®, VIX®, and it quickly became the benchmark for stock market volatility. It is widely followed and has been cited in hundreds of news articles in the Wall Street Journal, Barron’s and other leading financial publications. Since volatility often signifies financial turmoil, VIX is often referred to as the “investor fear gauge”.
VIX measures market expectation of near term volatility conveyed by stock index option prices. The original VIX was constructed using the implied volatilities of eight different OEX option series so that, at any given time, it represented the implied volatility of a hypothetical at-the-money OEX option with exactly 30 days to expiration.
The New VIX still measures the market’s expectation of 30-day volatility, but in a way
that conforms to the latest thinking and research among industry practitioners. The New VIX is based on S&P 500 index option prices and incorporates information from the volatility “skew” by using a wider range of strike prices rather than just at-the-money series.
VIX is based on real-time option prices, which reflect investors’ consensus view of future expected stock market volatility. Historically, during periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher is the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. Yes, the VIX has an inverse relationship to the stock market. It is important to note, however, that past performance does not necessarily indicate future results.
One common use of VIX is to gauge the market sentiment for clue of future direction. Conventionally, the market is considered high in volatility when the VIX is above 30 and low in volatility when it is below 20.
Figure 1
Throughout much of the period from March 2003 through to August 2007, the stock market had been low in volatility which corresponds to a bullish market of the time.
Figure 2
Figure 3
The current VIX suggests that the stock market has just begun its high volatility period, which indicates a bearish market. While the markets are slightly bullish for the past two months, we could be seeing the bounce of the bearish market, and not a sustaining bullish market.
Why Volatility Matters
Although VIX offers benefits of market sentiments and information on future direction, it affects options traders much more directly than it affects stock traders. Option is a financial derivative that derives its value from both intrinsic value and time value. Intrinsic value is the price differential between stock value and its in-the-money option’s exercise price. Time value is the added value that placed on top of the intrinsic value of the option. Time value has no objectively defined value or worth. It basically is a value that reflects the market’s perception of the future value of the options. All future, potentially realizable value should have been reflected in the current option price. When the market perception of option is high, its value will be high. If it is low, its value will be low. Therefore, time value is implied. For this reason, option’s volatility is often called as implied volatility.
Essentially, option’s time value is highly perceived, not real. It renders option pricing insurmountably arduous. Since fear is a perception and can be irrational, the follow-on reactions to fear become volatile. The amount of irrationality can cause unrealistic time value in all options. In addition to panic selling, there is also panic hedging by fund managers. Fund managers buy put options to protect their stock portfolio. This increases the demand for put options and hence its time value. Fear sentiment runs high. This explains why the high VIX is linked to the falling markets.
On the other hand, when the market is bullish, everybody’s mind is on profit. There is very little fear. Most investors would spend time calculating risk and not buy into options with high time value. In this situation, most of the options’ time values are relatively controlled and even low. Somehow, most investors could understand bullish market more than the bearish one. They know what to do during bullish time but lost when bear markets hit. It is the lack of understanding of bearish market that instills fear in the minds of these investors. Whatever the reason, we know that time value varies greatly in different market conditions. The differential could easily run above 30 percent of the total option value. No experienced options traders would ignore the magnitude of this degree of difference. This makes options trading more complex than stock trading as timing the move of the market is not enough. Volatility of market needs to be considered as well.
Options Trading in Low VIX
As you can see in Figure 1’s recent VIX chart, the SPX had just come down to below 20, suggesting low market volatility and a bullish market. As an options trader, we should adopt strategies that commensurate with the low VIX (or implied volatility) condition. Whilst there is no guarantee that the market could ever turn bearish at this time which would raise the VIX and potentially the time value of options, the wise options traders would only trade with options strategies that would benefit from a surge in implied volatility (IV). Since the market is already low in VIX, further drop in IV of options would be minimal or at least not detrimental to the trade position. This is how experienced options traders would act in this situation.
There are many options strategies that go well with the current low VIX market. The most simple of which would be just straight call or put options. It makes sense to buy straight options because any amount of increase in volatility would raise the time value – and therefore its net option value – higher.
If you are more inclined to complicated strategies with multiple legs, you may also consider the low risk calendar spread or put ratio backspread. Calendar spread is excellent because it has a very low capital requirement. It is also safe because there is very little to lose. Put ratio backspread is one my favorites as it is safe if you could find a low risk entry point with net credit. This complex strategy is also remarkably profitable if the market moves aggressively lower (as in a crash) due to the highly leveraged structure inherent with this strategy.
Straddle is an equally appropriate strategy to trade in low IV environment since you are going to buy two options at one time. This will lower your cost of buying and risk. A pump in IV will raise the values of both options which will benefit you as net buyer.
In summary, the following is the list of the strategies I would consider now:
- Straight Calls or Puts
- Calendar (or Time) spread (Long)
- Straddle/Strangle (Long)
- Put Ratio Backspread
- Call/Put Diagonal Spread
Do remember that technical analysis still applies in determining the type of markets that will prevail in the next trading period you are going to trade. If the market is bullish, it makes no sense to trade with put ratio spread. The volatility analysis must complement the technical analysis. When both analyses diverge, it is only rational that you pass up the trade. You only take position when everything is stacking up in your favor. The VIX is an important indicator which helps you to do just that.
Campbell Soup (CPB) breakout to the downside on 19 May with high volume. Is this a good take?