- It's difficult to know when exactly a bear market takes hold until after the event
- Mitigating the fear factor through the VIX index is one way of controlling volatility
- There are various strategies we can use on the VIX
- Product Watch is a new feature focusing on key products
Volatility can be sparked by all manner of things including the
battle for coveted oil resources in the South China Sea. Photo: iStock
By Georgio Stoev
We all went through the bliss of this past holiday season so determined to finish the year on a high note and even more determined to start the new year on an even one.
About 45% of Americans started 2017 with some sort of a lifestyle resolution – lose weight, spend more time with family and so on. (I, for one, am substituting cigarette smoking with nicotine gums. I am getting more addicted to them than I was to smoking).
But only 7% of the aforementioned 45% will keep those resolutions. It's tough enduring the ups and downs and putting the body and mind through stress. A few practices, like meditation, having support from a loved one could help the ones determined - "the steamrollers."
In the marketplace, we also are having to go through the ups and downs of these ups and downs. Just go back a year when, for a moment, we thought Armageddon was on its way from China. Markets tanked more than 10% and we all thought it was going to get worse.
It was another bear market in the works, but we cannot predict when a bear market has arrived until it has firmly manifested itself. Hindsight is always 20/20.
The 2016 Vix roller coaster
What can we do to control some of that volatility?
There are many ways to skin a cat and managing volatility is no exception.
Step 1. Determine what is it that you are trying to accomplish. Is it to hedge the risk in the market? On the entire portfolio?
Step 2. Understand what the products are before using them. This is where most of us will stumble, potentially get in trouble and end up giving up.
With so many choices of instruments on the Saxo platform, it feels like we are in Willy Wonka's Chocolate Factory. Which one is the right one?
The Chicago Board Options Exchange holds a long tradition in volatility products, among other flagship products, such as the S&P 500 Index Options (SPX). And, of course, the exchange pioneered the listing of equity options on blue chip names such as IBM, GE and many others. The year was 1973.
Among its flagship products the Volatility Index, also referred to as the fear factor, is a measure of near-term market expectation as measured by S&P 500 stock index options. There are a plethora of other products tracking volatility on currency pairs, financial instruments and of course equity options. For full product overview check out the exchange's website
Before we crack the code on the the product, here's the story behind the VIX. The VIX in its current form dates back from the early 1990s with its roots set in the 1980s, post the stock market crash of 1987.
Back then volatility was tracked by another volatility measure - the VXO which tracks the S&P 100 stock index.
The 1987 market crash
Coincidentally, in the late 80s, equities were making new highs on the back of fiscal and monetary stimulus. Moreover, in the months preceding Black Monday
, global interest was rising on concerns and of inflation, rising US government debt and of course extreme bullishness by investors.
In one day, the equity index lost 20% of its value. In the following three weeks, the S&P 500 suffered a 33% loss. At the same time the CBOE volatility index skyrocketed from $20 to a high of $155 or 675%.
Choosing the right volatility instrument/strategy
Trading investors sentiment for speculation or protection is a little trickier than most other vehicles. You cannot physically own indices such as the VIX or SPX. So market participants use futures or options as a hedge or to establish a given market view.
Equities vs volatility
To gain an upside exposure to in volatility or VIX, investors could either buy an outright call or do a combination with another option through our Multi-Leg Option ticket. At the time of writing, VIX is trading near $11.70. If you expect fear in the market to rise over the next couple of weeks, you could purchase a $15 call option for $1.15 or $115 per contract with 27 days to go. Your upside will be unlimited while you risk the premium paid of $1.15.
The above strategy could be extended through the use of a spread, such as the bull call spread. Using the same 15 February 17 expiration but different strike price we could reduce the cost of buying an outright option by simultaneously selling another. This is an example of a vertical spread - The 15 FEB 17 15/19 call spread would cost half the single leg at $0.55 and will provide for ample upside (width of spread minus premium paid or $4-$0.55).
This is how you do it
For those having access to futures trading you could consider a third option - the covered call. Using the underlying CBOE future, VXG7, you'd establish a long position in the future contract and sell a VIX option against it. The position is similar to selling a covered call on a stock you own. It is super important to trade same expiration on both the underlying and the option. The option is based on the future. In our case VXG7 (28 days to expiration) should be combined with the standard February expiration of 15 FEB 17.
Another important consideration is the size of the contracts. While the VIX options have a multiplier of 100, the underlying future has a size of 1000. So for every one contract of the future you'd need to sell 10 VIX options. Or:
Long +1 VXG7 1/1000 16 FEB 17 at $14.20
Short -10 VIX 1/100 15 FEB 17 16 CALL at $.90
To gain on such strategy the underlying needs to move up. Your profit will be capped to the strike price of $16 and you'd make the difference between the initial and closing value ($14.20 -$16) or $1.80 or $1,800 (x 1,000). In addition you get to keep the premium from selling the 10 contracts and increase your total return to $2,700 or 40% ROR (initial margin/profit).
Some important considerations
Whatever you are view of the market going forward might be, you should consider using futures and options to diversify and protect your portfolio.
You should take time to investigate every single product/strategy before employing with your capital. Look for liquidity, sell options when the VIX is high and buy options when volatility is low.
Use your long (stock) positions to reducing your cost basis and reduce the risk. The lower the cost basis, the greater the opportunity of success in that investment.
Please make sure and reserve your spot for the upcoming OptionsLab webinar
with special guest Russell Rhoads, CBOE director of education, as he provides an insight view of CBOE's long line of strategic instruments.
Handling volatility is key to a well-constructed portfolio. Photo: iStock
— Edited by Martin O'RourkeGeorgio Stoev is futures and options product manager at Saxo Bank