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As the VIX Falls, It's Time To Consider Buying Options

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After peaking above 80% during the darkest days of March, the level of index volatility has been falling steadily as the broad markets continue to recover from the selloff. On Thursday, the level of the CBOE Volatility Index touched the 30% level for the first time since February.

Source: CBOE.com

Just five weeks ago, I argued in Know Your Options that anyone who was considering protecting an equity portfolio with puts would be throwing away money because the high implied volatilities made them too expensive.

Well... five weeks seems pretty much like forever during the era of shelter-at-home and I’m about to make a complete about-face and argue that options are now actually getting too cheap.

Though 30% is still much higher than the longer term average - which was between 11-14% until the beginning of the Covid-19 selloff - it’s not at all unreasonable during a period when the major indices move 1-3% per day and no one is really certain whether stocks will continue to recover or reverse course and test the March 23rd lows.

A lot of it is going to depend on the success or failure of attempts to “re-open” the economy and also the trajectory of new virus infections/deaths figures. There are a lot of possibilities – from very optimistic to complete gloom-and-doom. If you’re not sure what to expect, you’re definitely not alone!

So let’s revisit an options trade from last Summer’s series on spread trading that profits from big moves in either direction – the Straddle.

In the trade, you simultaneously buy (or sell) a call and a put with the same strike price and same expiration date.

If you buy both options, you are said to be long the straddle and if you sell them you are short the straddle.

A long straddle benefits from two things – movement in the underlying away from the strike (actual volatility) and an increase in demand for options (implied volatility.) If the underlying fails to move, the prices of the options decays as time passes, reducing the value of the spread.

As you might expect, the short straddle has exactly the opposite characteristics. As time passes without movement in the underlying or if implied option volatilities fall, the short straddle is worth less – resulting in profits for the seller.

So if you believe stocks are going to move, but it could be in either direction, you’d buy a straddle. It’s a limited risk trade and the maximum loss is the total premium you paid for the two options. If the stock moves away from the strike by an amount greater than the premium paid, the trade will show profits. The maximum profit is unlimited to the upside and limited to the difference between the strike price and zero to the downside.

Example: Buy one SPY September 290 call @ $ 19.00 and buy one SPY September 290 put at $21.00. These options have 134 days to expiration. They’re currently priced at an implied volatility of just under 29%.

If the S&P 500 moves more than 13% in either direction between now and September, the trade will be profitable, but that’s not the only way to make money. If the index moved sharply lower, we can sell the put at a profit and hold on to the call for the possibility of a rebound. The same logic applies if we saw a steep rally, we can sell the call and retain downside profit potential if the rally fails.

Keep in mind though that time is not on our side in this trade. At the original prices, each option decays as time passes, so if nothing happens in the underlying or implied volatility, we lose money each night.

The time decay increases as expiration approaches. (The rate is the inverse of the square root of the amount of time remaining, if you’re interested in the math.) You probably want to close this trade prior to expiration, possibly even as early as a month before, depending on how well it’s working.

One Final Consideration – Historical vs. Implied Volatility

In general, because more market participants choose to be long options than short, implied volatilities tend to be a bit higher than the actual observed volatility of the underlying. The amount varies, but over long periods of time, it has generally been in the area of 2% higher in volatility terms – meaning that for options priced at 21%, the average movement in the shares over the life of the options is usually closer to 19%.

This premium is not insurmountable if you have an effective thesis for why the underlying is more likely to move than option prices would suggest, but it’s worth noting that supply and demand concerns mean you have slightly less margin for error when you are a net purchaser of options in a spread than when you are a net seller.

Right now, there’s no way anyone could reasonably forecast what future volatility will be.

In the current environment, the straddle might be the best possible trade if you feel like something big is going to happen, but you’re just not sure what it will be.

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.

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