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23
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Vol Watch
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Viewing the markets
through the eyes
of volatility
SEE
GLOSSARY
PAGE 46
Volatility is often low
during the summer
months, only to historically rise in the fall.
While there is risk in a
long vega position if the
VIX goes from 16% to
14%, it’s not as great as
when volatility is 30%
and drops to 20%.
• Now you see it, now you don’t. Market
volatility (measured by CBOE’s VIX
volatility index) stubbornly persisted
under 20% for several months until it
broke out in July of this year. By August, it
spiked as high as 48%. Could you have
known what expected future volatility
was when the VIX was only about 16% in
early July? Well, using VIX option prices
to estimate the market’s expectation of its
future value, at that time, the October VIX
was at 22%, the November VIX was at
22.8%, and December was at 23%—
indicating a possibility of higher future
implied volatility.
Low Vol… Yum, Yum
•
Volatility, like a spring, will recoil again.
When it does, be ready.
GOING VERTICAL
One strategy with positive vega is the long
at-the-money vertical spread. When
volatility is lower, the extrinsic value of
the first in-the-money option is lower, too.
Creating long vertical spreads by buying
that first in-the-money option and selling
an out-of-the-money option one or two
strikes away can have a debit that is less
than the intrinsic value of the long option
at expiration. What does that mean?
Look at the intrinsic value of the option
that is one strike in-the-money. Now com-
pare it to the price of the option, which is
the sum of the intrinsic and extrinsic value.
If you can sell the out-of-the money option
for close to the extrinsic value of the long
option, then you are establishing the long
vertical for close to the intrinsic value of the
long option. That means that if the stock
stays right where it is, the spread won’t lose
much money. It’s harder to establish long
at-the-money verticals at these prices dur-
ing periods of higher volatility.
WITH VOL ALL OVER
the map this year, who
knows where it will be
by the time you read
this. But when the VIX
eventually comes down
from its perch, and you
believe that there is sup-
port for the VIX at a cer-
tain level (look at your
charts), you could use
dips in volatility to estab-
lish long vega positions.
Keep in mind that an
increase in implied
volatility does not have
to be accompanied by an
increase in the magni-
tude of percentage price changes in an
index or stock. That’s one reason to possi-
bly avoid simply buying calls and puts,
even though they would have positive vega.
Words by Thomas Preston
Photograph by Fredrik Brodén
WHEN VOL KEEPS FALLING
The question is, though, when volatility is
low, and you establish a position that has
positive vega, aren’t you at risk if volatility
falls? Sure. But how much risk is there that
the VIX would fall from 16% to, say, 12%,
and how great a loss would that create for
a long vega position? For example, if the
vega in a two-month vertical spread in S&P
500 options is approximately +0.10, that
means a long vertical spread worth, say,
2.00 with volatility at 16% today could
drop to 1.60 if volatility drops to 12%.
In ten years, the VIX has not dropped
below 9%, and it has rarely dropped below
14% (source: thinkorswim Charts).
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The information contained in this article is
not intended to be investment advice and is
for educational purposes only. Multi-legged
option strategies such as those discussed in
this article will have additional costs due to
the additional strikes traded. Be sure to
understand all risks involved with each
strategy, including transaction costs, before
attempting to place any trade. Be aware that
assignment on short option strategies discussed in this article could lead to unwanted
long or short positions on the underlying
security. Clients must consider all relevant
risk factors, including their own personal
financial situations, before trading. Options
involve risk and are not suitable for all
investors. Supporting documentation for
any claims, comparisons, statistics, or other
technical data will be supplied upon request.
