If you're a market watcher like I am, than you may also remember watching the futures action on November 8. Starting at 10:00AM Eastern time the Dow Jones Mini Futures (/YM) began a steady climb from 18,155 to 18,295 by Noon. Then they took a little breather until 3:00PM and peaked at 18,387 around 8:00PM. What happened next was nothing less than dramatic. The 8:00PM hour opened at 18,381. As it was becoming apparent that Donald J Trump was likely going to be our next president (despite what the polls, and markets, had only recently predicted), the Dow futures began a sickening decline, bottoming at 17,418 between the Midnight and 1:00AM hours (almost a quadruple digit decline in the span of 5 hours). Put differently, a trader short of one contract in the Dow futures would have pocketed a profit of $4,815 from peak to trough. Not bad!
If the decline was sickening, the subsequent rise on November 9 was equally as breathtaking. During the 11:00AM hour, the Dow futures had traded back up to the 18,381 level, and kept on going. On Friday, February 3, the Dow futures closed at 19,994; 1,613 points higher.
What is amazing to me is how quickly the market's about face occurred the evening of November 8 and the subsequent morning. In almost the blink of an eye, markets went from the perception that a Trump presidency would be disastrous for the U.S. and global economy; to the current perception that a Trump presidency will unlock unprecedented value and economic prosperity. These sudden, rapid, unexpected price changes are the classic definition that most people think of when they think of the word "volatility".
The Chicago Board Options Exchange (NASDAQ:CBOE) definition of volatility is different. The CBOE Volatility Index (VIX) is an index based on the real-time prices of options on the S&P 500 Index (SPX). It is intended to reflect investor sentiment and views of expected future (30 day) volatility of the stock market. It is often referred to as the "fear" index. Options, like those on the SPX, are often employed as a hedge against stock market volatility. As investor sentiment turns away from "greed" and towards "fear" (fear that market pricing will turn against their positions, whatever those positions may be) some investors may utilize options to hedge a position or an entire portfolio in the face of uncertainty.
Like any other supply and demand situation, the premiums on options inflate as more investors turn towards them for hedging purposes. An option's price (premium) is determined by five objective variables and one subjective variable:
- Intrinsic Value (determined by the option's strike price and the current price of the underlying security)
- Time to Expiration
- Interest Rates
- Cash Dividends
- Historical Volatility
- Implied Volatility (IV)
Let's say, for example, an option has a fair market value of $2.00 (based on the first five variables). If the price increases to $2.40 (your first five variables remaining steady), then we would say the additional $0.40 is attributable to the Implied Volatility of the option. Put differently, an investor holding this option purchased at fair market value enjoys a 20% profit because enough other investors sought to add this option to their portfolio, thereby bidding up the price.
It is this options "mispricing" that we are going to seek to capitalize on in structuring an options trade, for speculative rather than for hedging purposes. That is not to say that one could not add such a position to their portfolio as a hedge (depending on the composition of said portfolio). However, the reasoning and methodology I am about to take you through are really more appropriately categorized as being "speculative" in nature. Be careful about equating "speculative" with "high-risk". An investment in a start-up biotech company could also be labeled as "speculative". I would consider the latter investment to be much higher risk, because it is much less risk-defined than the structure I am about to go into.
So, we've just discussed the "what", which is a play on volatility; more specifically, volatility in the form of the CBOE VIX Index. Now, we will talk about the "why" (we'll get to "how" in the next section).
Let's go back to November 8 of last year. We already discussed what the Dow futures were doing. It's worth noting that the S&P 500 futures (/ES) behaved in a very similar fashion (since we will be focusing on the S&P 500 as an index for the remainder of this discussion). Please refer to the two charts below for a side-by-side comparison of the Dow and S&P 500 futures:
Please pay particular attention to the red arrow on both charts; it is pointing to the long wick of the election night candle for both the Dow and S&P 500 futures (indicating, as explained earlier, a sharp fall in prices followed by a subsequent sharp rise in prices). As you can see from both charts, traders in both the Dow and S&P 500 futures drew the same conclusion on November 9: Namely, that a Trump victory ultimately meant less regulation, more infrastructure spending and an overall "freeing" of the economy, which of course bodes well for the general stock market.
That sentiment continued until about mid-December, when price action began to move sidewise; and consolidated even further in early January as investors began to adopt a "show-me" attitude, waiting for more definitive signs that would indicate whether the Trump administration would be able to work with Congress to push through what is admittedly a very ambitious domestic agenda.
Now, let's take a look at how the VIX behaved during that same time-frame. Below we have a comparison chart, on which we have plotted both the SPX (blue line) and the VIX (purple line). One observation that immediately jumps out is that the two indexes are roughly negatively correlated. That is to say, as VIX rises, SPX tends to fall, and vice-versa.
A closer look also reveals a couple of additional observations:
- A rise in VIX often precedes a decline in SPX by several bars
- VIX and SPX don't always diverge. In other words, a rise in VIX is often, but not always, accompanied by a decline in SPX
This is due simply to the fact that VIX is a measure not of pricing direction but of investor sentiment regarding the expected price direction. Put differently, if I as an investor expect impending downward pricing pressure on my portfolio, than I (along with thousands of other investors who expect the same development) will purchase some form of options to protect my portfolio before my hunch is proven right. Implied Volatility rises before the actual volatility manifests itself. By the same token, sometimes I and my fellow investors are wrong; the pricing correction doesn't occur despite my fears, yet VIX rises all the same.
Referring again to the chart, please note the rectangular area shaded in grey; this area represents the days leading up to, and immediately following, the November 8 election. The small white circle indicates election day itself. You can see that immediately following the election, SPX proceeded to move in an overall bullish, upward trend; while VIX proceeded to move in an overall downward trend.
Next, we turn our attention to a weekly plot of VIX itself (below), with a few added drawings and studies. The red horizontal line represents a level of support, which until now VIX has held above. You'll see that most of the price action dating back to the week of February 8, 2016 is contained within the orange regression channel (width is one standard deviation). You will find three spots (marked by the large, upward pointing green arrows), in which the VIX touched the bottom of support (both the regression channel as well as the horizontal line of support) and bounced. Additionally, two areas (indicated by the small red arrows pointing downward) are areas where the VIX could not be contained by the regression channel, spiking up dramatically before reverting back to within the channel. This suggests significant support at the 10.72 level. On the other hand, there is very little resistance to the upward movements of VIX; the bias, if there is any, is to the upside. This would seem to affirm much of the commentary we are hearing on the VIX--coming from the likes of Bloomberg and CNBC--that with the VIX at such low levels the likely future intermediate term move is up.
It is worth noting here that the rationale for an increase in Implied Volatility in the intermediate-term has more to it than the simply technical reasons outlined above. For VIX to go up there really needs to be a cause. Given the current political climate, traders and investors alike have no shortage of reasons to flip the switch from greed to fear. We've already witnessed the power of the Presidential Tweet and the impact it can have on the stock of individual companies as well as entire markets. With the President only recently getting his cabinet named and approved, more detail has yet to come out about the imperatives he outlined for his first 100 days. In short, the same reasons that sent indices rocketing up and VIX plummeting down can cause just as sharp of a reversal if those reasons no longer seem as valid.
Returning to the technical, let's turn our attention to the MACD and Stochastic studies at the bottom of this chart. We can see that the week of January 23 VIX made a bullish Stochastic crossover; and that a bullish MACD crossover may be soon in the cards. Additionally, we can see that the chart is forming a slightly less than perfect double-bottom formation. Taken altogether we can conclude that, although the VIX doesn't have to move upward from these low levels, the odds certainly do seem to favor it, especially over the intermediate-term. Fortunately, as we will discuss in the next section, the structure of the trade does give us a good amount of time to be right.
Structuring the Trade
As mentioned in the introduction, options traders like to buy premium when volatility is low, with the idea that future increases in volatility will create profitable "premium expansion", independent of any favorable price action in the underlying security. As we know, VIX often moves up (or down) before SPX starts to move down (or up). The reason for this makes perfect sense; if these traders are correct, and price volatility is in the cards, it would make more sense to buy the insurance before they need it (i.e.., before the anticipated volatility manifests itself).
In options parlance, the two types of trades we can consider for this strategy are either a "straddle" or a "strangle":
- A straddle consists of two long options, one call and one put, at the strike price closest to the current price of the underlying security
- A strangle consists of two long options, one call and one put, with strike prices on either side of the current price of the underlying security.
In selecting our strategy we need to be sensitive to two considerations: one is vega and the other is theta. Vega is a measure of the option's price sensitivity to changes in the volatility of the underlying asset. A vega of 1.45 would mean that for every 1% increase/decrease in the volatility, the option's price increases/decreases by $1.45. Theta (or time decay) is a measure of the rate of decline of an option's value with the passage of time. An option with a theta of .02 loses $0.02 in value each day. It should be noted that time decay accelerates in an exponential fashion as the option nears its expiration. Given these two considerations, we would like to pick an option structure that maximizes our vega and minimizes our theta. As we will see, long-dated options with strike prices at or near the current price of the underlying security are a solid choice.
Below we see the options chain for the SPDR S&P 500 ETF (NYSEARCA:SPY). While there are options available on SPX directly, the premiums are substantially higher since they are linked to an index value that is ten times that of SPY. You could certainly execute this strategy with SPX options; but for purposes of this article we will discuss options on SPY as a proxy for SPX.
We are looking at the options series with the December 20, 2019 expiration. Let's start by analyzing a possible straddle on SPY. As you can see, SPY as of this writing is trading just a little above 229. Looking at the 230 strike. We see that the vega for the 230 call is 1.46, and 1.45 for the equivalent put. This means that for every 1% increase in the IV of SPY, our straddle will increase in value by $2.91. Conversely, for every 1% decrease in the IV of SPY, our straddle will decrease in value by the same amount.
You'll also note that the theta for each leg of the position is insignificant compared to vega. Each day that goes by, our position will lose $0.03 of value. (-0.01 theta for the call and -0.02 for the put). Theta will, over time, become a more significant drag on positional value. However, the options we are using are so long-dated that we most likely will have exited the position and banked our profits well before then.
Alternatively, we can choose to use a strangle for this strategy. An advantage to using a strangle is that, because it is composed of two out-of-the-money options, the total premium commitment is lower. The disadvantages are that the vega will be a little less, as well as the fact that SPY would have to make a bigger move (as compared to the straddle) one way or the other in order to profit from any resulting change in the intrinsic value of our position.
In the above illustration we are looking at the 280 Call (vega of 1.06 and theta of near 0.00) and the 170 put (vega of 0.99 and theta of -0.01).
Shortly we will be looking at a risk profile that compares these two trades and the P/L of each. But first, let's take a look at the past behavior of the Implied Volatility of SPY so that we can get a general idea of what to expect and define possible entry and exit points for our trade.
Past Implied Volatility of SPY
Below we have a weekly chart of SPY dating back to January, 2005. At the bottom of this chart we find a plot of the Implied Volatility of SPY over this same timeframe. For visual purposes two green bands have been placed at the bottom of the IV plot, one at 0.1034 (recent lows) and the other at 0.13.
Each instance of the IV dipping below the 0.13 level has been marked with a colored arrow at it's trough. Another arrow of the same color has been placed at the peak of the move, when IV rose back above the 0.13 threshold before reversing. There are twenty of these instances plotted on this chart, which have been summarized in the table below. This table tells us the date the move began, the IV reading at its trough and its peak, the date the move ended, the difference between the beginning and ending IV readings, and how many days the move lasted from trough to peak.
|Beginning||Trough||Peak||End||IV Move||Time (Days)|
Taking an average of the figures in the "IV Move" column gives us a figure of 7.03. Alternatively we can look at the midpoint between the highest and lowest number in the column, which is 11.74. We have also calculated the average duration of the moves, which comes to a little over 45 days (week days). These results will help us to evaluate the proposed trade, now that we have a better idea of the magnitude of the move we may expect. We can also project how many days it might take so that we can calculate our negative theta burn as well as our potential volatility premium expansion on our P/L.
Below we have depicted a standard options risk profile. The purple curve represents the nearer-term P/L, while the blue curve represents the P/L at the position's expiration. We have fast-forwarded the time element to April 13, 2017, which is 46 days in the future (the average move duration from the data above). We can see that, holding SPY price a constant, that the position will be upside down by approximately $161 as of April 13 due to the time decay (theta). At expiration the maximum loss would be around $5196 (approximate premium paid for the position). These figures assume no change in volatility.
Next let's assume that IV increases by 0.10 during the 45 days we hold the position. Our P/L for this scenario is detailed below. Notice that, while our maximum risk has not changed, our near-term P/L has increased and is now a little over $2,600. This is due to the fact that the increase in IV has expanded the value of our long position, without the price of SPY itself needing to change. Of course, if the price of SPY does change by a large enough figure, we can also start to capture additional profit due to the increase of the intrinsic value of our position. As you can see, however, a price change in SPY in either direction is not necessary in order for this trade to be profitable, just as long as IV increases as we think it will.
Now, what if IV actually comes in rather than increasing? The illustration below shows us what would happen if IV decreased by 0.02. In this case our, positional loss has increased from $169.13 to a little over $724.
The series of illustrations below shows us the same detail for an out-of-the-money strangle rather than an at-the-money straddle. As of April 13 with no change in SPY price and no change in IV, our position is sitting on a small loss of a little over $113 due to time decay. Notice that our maximum loss for this position at expiration is $1551.
Next, with a 0.10 increase in IV, our position has now swing to a profit, to the tune of a little over $2100.
Finally, if volatility comes in by 0.02, our loss has swung to a little over $484.
As you can see, long straddles and strangles can be a nice addition to the trader's toolbox, especially in a low volatility environment that, nonetheless, is not free of dark clouds gathering on the horizon in the form of potential economic and political uncertainty. The risk/reward ratio for this particular strategy seems to be a compelling one, and hopefully this exposition will help the reader in collecting ideas that generate a profit even when it is unknown whether markets will go up, down or sideways.
Disclosure: I am/we are long SPY.
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.
Additional disclosure: I am long of a strangle in SPY.