Rising Volatilities Are an Opportunity

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The equity markets have been trending mostly in a positive direction since March lows, but the CBOE Volatility Index has been staying consistently higher than recent averages.

In general, the VIX increases quickly when equity prices decline and ebbs when prices are rising, though its current equilibrium level is higher than it has been over the previous several years and much closer to – or even above – long term historical averages.

For many years, trading in VIX derivatives held the index artificially low. A wide range of traders from small retail investors to relatively sophisticated professional shops found the apparent easy money in the VIX to be irresistible. They shorted the VIX every time it rose – using futures, options and inverse ETFs/ETNs and profited handsomely…for a while.

Huge spikes in volatility during some of the steeper selloffs wiped out most of these traders. We documented that effect when VIX trading profits started showing up on big banks’ quarterly reports.

Many traders suffered losses in excess of the value of their accounts, especially those who were using leveraged ETNs, leaving their brokerage and clearing firms with significant debts.

Ultimately, there’s not much difference between being short the VIX and being short equity index options. Both involve significant risk.

Big trading desks that had the patience and foresight to stay long volatility – knowing that it would spike sooner or later – cleaned up.

In March, the VIX topped 80% for an extended period of time. A lot of money changed hands.

Short volatility strategies tend to blow up eventually. Though they appear to work for a while, practitioners are really borrowing the money from the markets rather than actually earning it.  When it comes time to pay the debt back, it’s usually very painful.

While that trade was working in 2013-2018, the effect of all that money available to sell volatility had a depressive effect on the VIX. Other than a few short-lived increases, the index stayed in the low double digits for long stretches.

Over the long term, the observed volatility of the S&P 500 is between 15-17% – depending on the length of the period used for the calculation – and the implied volatility of options tends to be 1-2% higher than observed actual volatility.

That would mean the equilibrium level for the VIX is 16-19%, which is above where the VIX index traded until the Covid-19 pandemic.

Now that those chasing easy profits have been flushed from the markets, the VIX seems to be floating back to more normal levels.

This Fall, there is so much uncertainty facing the financial markets that implied volatilities are likely to stay at elevated levels or move higher. I’d be very surprised to see the VIX back in the 12% area anytime in 2020.

What does that mean for the average investor?

There’s profit out there, but it’s going to be uncomfortable to obtain. Implied volatilities spike when even the most rational professional traders get nervous and pay up for options to cover risk.

That’s when you can capitalize on the fear of others. During the most gut-wrenching days when the markets are moving lower and implied volatilities are soaring, that’s when you want to sell puts on stocks – or indices – that you want to own over the longer term.

The opposite goes for selling calls. When a stock you own makes a big move higher and you’re undecided on whether it’s time to ring the register and cash out, it might be a great trade to sell calls against it. You don’t have to let go of the entire position – after all, it’s working. Consider selling enough calls to sell half the position if it keeps rallying and also keep the premium you collect as an added bonus.

If the stock reverses course and sells back off, you still keep the premiums.

These are not necessarily new strategies for regular Know Your Options readers, but the points are so important that they bear repeating. The name of the game is to,” buy low and sell high” but it doesn’t have to happen in that specific order.

When options are expensive, you can do your selling first.

-Dave

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

 

 

 

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Greg
Greg

Trader pour compte propre. Je partage avec vous, des analyses et contenus simplifiés. Je vous invite à nous rejoindre et à partager vos stratégies sur le Forum, avec d'autres investisseurs. Vous devez savoir, qu’investir sur les marchés financiers fait rêver plus d’un, mais n’est pas adapté à tous ! N’oubliez jamais que le risque de tout perdre est permanent.

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