A Recent Hike In Volatility Uncovers An Interesting Non-Directional Opportunity In S&P 500's Options

| About: SPDR S&P (SPY)

Summary

Yesterday, VIX surged by over 5%. Historical data show that this was a rare event. VIX bottomed a month ago and keeps trading sideways.

Because volatility indexes are mean-reversible, I expect VIX to return to its normal range, rising from the oversold territory.

S&P 500's options are the cheapest in terms of volatility, as historical information suggests.

The Fed is holding a meeting next week. I believe this will increase volatility on the market in the short-term.

I offer two options trades, which are mispriced relative to historical volatility. I expect a 50%+ return in straddles expiring in the end of May 2016.

In a recent video, ex-CBOE trader Jonathan Rose, whom I follow closely, stated that the VIX index (NYSEARCA:VXX) is trading too low - to a point where it cannot go any lower. Remember that volatility indexes are mean-reversible, meaning that they cannot grow or decline forever. VIX is no exception, and the recent data have proven this yet again:

Click to enlarge

(Source: Google Finance)

Volatility indexes are strongly correlated with the underlying stock indexes they are based on. When volatility goes up, equity indexes go down - this is a simple rule. As always, historical data back this assumption visually:

Click to enlarge

(Source: Google Finance)

The above chart shows dynamics for S&P 500 and its volatility index, VIX, for the last three months.

As you can see from the chart, as volatility went down from the highs of January 2016, S&P 500 (we will use the SPDR S&P 500 ETF Trust in this article as a proxy for the S&P 500 index, which is not directly tradable) crawled higher. In fact, the equity index has shown a return of almost 12% since the beginning of the year, while the volatility index has lost almost 50% of its value.

What you should also see here is that the volatility index has bottomed: it has remained in the same bandwidth (-40% to -50%) for the entire month of April. Yesterday, it went up by over 5%.

My historical data analysis (using daily price data for the last year) shows that a one-standard deviation change in daily prices for VIX is about 4.9% (that is, a "normal" absolute change in price that has a 68% chance of occurring, if the distribution of the price changes is normal). However, the price changes' distribution is not completely normal because, as empirical evidence shows: there is only a ~27% chance of seeing a change greater than 4.9%.

In fact, there is only a 13% chance of seeing the VIX going higher than 4.9% in a whole year. We can therefore infer that the change in VIX yesterday was out-of-ordinary. The change in the value of the index has found itself between one standard deviation (4.9%) and two standard deviations (9.7%). This is significant and may mean that the volatility can embark on an uptrend pretty soon. The upcoming Fed meeting is also not going to reduce volatility on the markets.

VIX is strongly correlated with S&P 500 (NYSEARCA:SPY), as evident from the illustration below:

(Source: Google Finance data . Calculations by author)

The R^2 reading of 0.7677 may not seem very strong, however, the R reading of 0.8762 suggest that the correlation between daily price changes between the two indexes is extremely strong.

In addition, my analysis shows that the two indexes strongly correlate during two-standard-deviation events in over 58% of time:

Click to enlarge

(Source: Google Finance data. Calculations by author)

There have been 12 events in the past 52 weeks when either the VXX or S&P 500 indexes moved by two standard deviations a day (and they did so simultaneously 7 times out of 12).

As opposed to VIX, S&P 500 has historically shown relatively low volatility in daily price changes:

(Source: Google Finance data. Calculations by author)

The above calculations use daily price changes' data for the last 52 weeks.

As you can also see in the above chart, SPY's volatility has gone down significantly in the past thirteen weeks (one quarter): the annualized volatility is at the 52-week low (10.13%) and has demonstrated the largest decline in the 52-week period analyzed.

This low volatility, coupled with the upcoming Fed meeting and the mean-reversible nature of VIX, presents in interesting non-directional opportunity in SPY's options:

Click to enlarge

(Source: TD Waterhouse)

Click to enlarge

(Source: TD Waterhouse)

My trade idea is to buy options in one of the expiration dates presented in the tables above. Because I only want to choose one trade, I have to pick the most attractive one. In this case, the most attractive trade is the one that is the most mispriced relative to its future volatility. Below is given the cost of the straddles calculated using the ask prices to ensure conservatism in calculations:

(Source: TD Waterhouse's data. Calculations by author)

The relative cost is calculated by dividing the price of the straddle by the current market value of the underlying (approximately $209 per unit).

For convenience purposes, let us recall the historical standard deviation of daily returns' table on the S&P 500 index:​

(Source: Google Finance data. Calculations by author)

Let us examine the two straddles. The one-week straddle (expiring on April 29, 2016) is worth about 1.5% of the current market price of the underlying, which is slightly more expensive than the calculated weekly volatility of the underlying based on the last four-week data (~1.4%). On the other hand, it is undervalued relative to the three-month and the six-month weekly volatility averages (2.22% and 2.34%, respectively).

The one-month straddle (expiring on May 27, 2016) costs only 3.11% of the current market price of one SPY's unit. It is overvalued relative to the four-week average monthly standard deviation of returns but is undervalued relative to other historical points on the chart above. If its cost increases to match the three-month volatility reading on the chart (calculated to be 4.55%), the straddle will gain at least 15%, fees and taxes excluded. If the volatility climbs up to the 26-week average monthly standard deviation, the value of the straddle will increase by at least 54%!

My choice is the May straddle for two reasons:

(1) A one-week period offered by the April straddle may not be long enough for the volatility index to rise significantly. By buying a longer-term options I am effectively increasing my chances to catch an upside in VIX.

(2) The next Fed meeting is on April 26-27. This gives the April option only two days to capture volatility. If the market does not react to the meeting's results immediately, the straddle will automatically lose its biggest (and only) catalyst. I do not want to bet my money on the outcome of only one event.

Now let us summarize the key points in this trade idea:

(1) Equity indexes are correlated with their volatility indexes;

(2) Volatility indexes are mean-reversible. VIX, the key volatility index on the market, has bottomed and showed a massive gain yesterday. The probability of such event is quite low, as historical data show;

(3) The options on the equity index of my choice, SPY, have not yet reflected this change in volatility;

(4) Historical data on the daily returns in the equity index show that volatility has been declining for the past six months. Hence, the straddles are very cheap relative to historical volatility data;

(5) I intend to buy the May straddle because it shows the most upside from the two straddles of my choice. It offers the highest potential return, if the volatility returns to its mean levels;

(6) I believe that the upcoming Fed meeting will be another source of volatility.

Below is given a risk-return illustration for the May straddles:

(Source:​optionsprofitcalculator.com)

The above chart shows values for the May straddle at different market levels of the underlying given various dates. The maximum loss is $650 per contract (one options contract is one hundred shares), while the maximum gain is theoretically unlimited. The break-even levels in the underlying are $215.50 and $202.50 at expiration (May 27, 2016).

Based on the assumptions outlined above and the favorable risk-reward ratio, I find the trade very attractive.

Keep in mind that options are volatile instruments. With this particular trade, there is a possibility of a significant loss in the principal.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.