Meet Your New Friend: Volatility
Last week I introduced you to two calendar trades to take advantage of low volatility in the options market, which is great for scenarios when the market is calm and slowly chugging along. Late last week the market got spooked and started swan diving on us, so how do we change our game plan to take advantage of the down move? Good thing for you, my trade this week is designed exactly for this situation. But first, let’s learn more about volatility.
What is high volatility?
Remember that last week that we described volatility as the “black box” factor that is derived from an options price. But what exactly does an increase in volatility mean? Let’s look at this as if we are an institutional money manager.
Pretend for a moment that you’re a big time portfolio manager for a hedge fund or mutual fund. You’ve got a high pressure job because you are always worried about one thing—your numbers (the measured return for you fund). The biggest thing that can go wrong is a crash—either the whole market crashes or one of the companies you’ve invested in crashes—and your numbers will suffer, and more importantly, your bonus will shrink from “second house in the Hamptons” to “first months rent up front in New Jersey.”
Lucky for you, the market offers a form of insurance you can buy to hedge against a crash, and that insurance comes in the form of put options. If you own a company’s stock, you can buy put options for the underlying stock to eliminate your risk that the stock price falls below the strike price you select. If your portfolio is exposed to the entire market falling, you can buy put options as protection against a specific market index falling below a certain level.
One day you drive into work and park in your special “Reserved for Mr. Portfolio Manager” parking space and head into the office. You fire up the computer, start reading the news for the day, and after ten minutes your heart is racing, and your palms are sweaty. There is a bevy of news that you think has the potential to tank the market. You quickly assess how to minimize your fund’s losses and you decide you are going to buy SPX puts when the market opens to keep things from getting ugly (SPX puts are put contracts that settle in cash based on the underlying stock prices in the S&P 500 at expiration). Notice that YOU DID NOT DECIDE TO SELL ANYTHING in your portfolio, instead you are actually BUYING a derivatives contract as a form of insurance. The problem is that many of your competitors have the same idea, so now you are all willing to pay more for the same put contracts.
Let’s slow things down and figure out what’s happening here. We are about to buy a put contract with a value or price that is based on:
1. the underlying value of the S&P 500
2. the time until maturity
4. interest rates.
Notice that the news we read hasn’t actually moved the market or changed the value of the S&P 500, it has only made lots of portfolio managers want to buy insurance against the S&P 500 falling. This is a supply and demand issue: when more people want to buy insurance, insurance gets more expensive. Market makers who determine the bid and ask price for SPX options will raise the ask price for these options. Since the price of the options is now a higher price than before, but factors 1, 2, and 4 didn’t change, that means the new options price can be explained by a rise in volatility.
A rise in volatility means that people are willing to pay more for the same options. The options are now more expensive to buy then they were yesterday. We can quickly see how expensive the options are because the implied volatility number is now higher, which means MORE PEOPLE ARE EXPECTING THE MARKET TO GO DOWN even though it has not moved down yet.
If you understood what you just read, give yourself a pat on the back—you can now follow the VIX and know how scared investors in the market are. The VIX is an average reading of the volatility for the SPX options trading in the next two months. The VIX is referred to as the “investor fear gauge.” (Read a detailed explanation of the VIX calculation). When the VIX is high it means people are willing to pay more for the same options, so people expect the market to move.
If you think of an option contract as a flood insurance contract, decide if you would rather sell flood insurance on a clear and sunny day when it hasn’t rained in weeks, or if you would rather sell flood insurance when there are ominous clouds in the sky, the weather man is directing you to build an ark, and Johnny Cash’s “Five Feet High and Rising” is playing on the radio? It may not be raining yet, but you will sign contracts with higher premiums and collect more money during the latter scenario. But does this mean you will make more money? You actually don’t know—you will sell insurance for lower premiums on the clear and sunny day, but the risk of a flood is low compared to what you know in scenario two. You will collect higher premiums in scenario two, but given what we know about the clouds on the horizon insurance buyers are paying more because there is higher probability of a flood. And if the flood comes—the insurance company will take a loss. Ideally, you would sell insurance after a flood when the flood waters are receding. Buyers of insurance after a flood are scared and will pay more for insurance and you hope to capitalize on this fear.
All of this talk about “options as insurance” and selling volatility brings us to our trade this week. This week we sold a vertical spread. You can create this spread with puts or calls and you can be a buyer or seller of the spread. To sell a vertical put spread, you sell an out of the money put option in a specific underlying and then buy a put option in the same underlying, but at a lower strike price.
Trade of the week
Sold a Vertical IWM Oct 08 69/67 Put @ $0.52
This means I sold the IWM Oct 08 69 put for $1.60 while simultaneously buying the IWM Oct 08 67 put for $1.08, so I received a credit of $0.52 for establishing this position. In my insurance salesman scenario, I am hoping the flood waters are receding and that the IWM has bottomed out and will head back up.
The spread was sold for $0.52, but each IWM put contract is for 100 shares, so if you were to do this trade you would receive $52.00 less commissions for each spread you sell. So why not do this trade 100,000 times and retire with $5.2 million? You have to remember that you are taking a risk to make your $52.00. The worst thing that can happen to me is that the IWM settles below 67.00 at expiration in October, and if that happens I will lose $1.48 (or $148 per contract). My total possible loss on this spread is equal to the width of the vertical spread’s strike prices less the credit you receive, in this case $2.00 less $0.52). I break even if IWM settles at $68.48 and I get to keep the entire $0.52 if IWM settles above 69.00 at expiration. As far as the number of contract you want to trade—if you allocate $500 per trade you should do 3 vertical spreads ($148/spread x 3 times = total risk of $444). If you allocate $1,500 per trade you could sell 10 of these verticals ($148/spread x 10 = $1,480). It is important that you use a trading platform that allows you to buy and sell the two legs of this trade simultaneously. It is dangerous to sell the first contact and then hope to buy the second contract in a separate trade. The market can and does move quickly and if it goes the wrong way, your defined risk strategy can turn into a “hope, pray, and hide under the bed until the carnage is over” strategy.
So why did I make this trade? Selling a vertical spread is a good way to collect premium while limiting your downside. It is also a good trade to take advantage of drop in the underlying and a rise in volatility. When I put this trade on IWM had fallen to about 72.20 and the RVX was up around 27.80. My feeling was that IWM would rebound back to around 74. The market actually dropped further after I put the trade on (so I didn’t time the bottom perfectly), but at the time I felt the risk of $1.48 was worth the $0.52 I was collecting because this trade would be a winner as long as IWM closes above 68.48 on October 19.
Selling a vertical spread will benefit from our friend volatility falling as well. The put option we are short is more sensitive to changes in volatility than the options we are long, so a drop in the RVX (the Russell 2000’s version of the VIX) back to around 24 will help this trade.
Next week we will talk about a strategy called an “iron condor” which takes advantage of selling a put vertical and a call vertical in the same underlying, in the same month, and at the same time.
Until next week, good luck trading!
Jonathan Weiner is Vice President of Maryland China Company. His work experience includes three years on Wall Street as an investment banking analyst for Wasserstein Perella & Co. in their Financial Institutions and Restructuring Groups.
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