- Volatility continues to lie low
- Crude prices one major mover
- Investors bidding up VIX calls
Low volatility means that trading has become a tough slog in many assets, but there
do exist solid options strategies for calm markets like these. Photo: iStock
By Georgio Stoev
US equities continued their grind, so relevant in the month of August, but closed the week with a modest rally. On Friday, the US unemployment numbers came in mixed – the US economy added some 151,000 jobs while the unemployment rate steadied at 4.9%.
The release saw little increase in hourly wages, which is something the Federal Reserve is watching closely and now investors believe that the central bank is not likely to increase interest rates in September.
Let's check in with other asset classes...
As one can see, volatility as measured by underlying price movement was almost non-existent over the past week. It honestly makes you wonder whether traders have just gone to Las Vegas and taken their chances at the poker tables!
Nowadays, one has to look very hard to find some movement in the marketplace.
One such place has been oil.
Crude oil for October delivery (CLV6) was one of the largest movers for the week. Oil was under severe pressure, hitting a low of $43.34/barrel in Thursday's trading. Oil and stocks have a positive correlation and have moved in tandem for the better part of the year (the pair decoupled in early July after US producers increased production).
As of time of this writing, futures are up nearly 3% and we are now looking for the commodity to bridge the gap with the equity index.
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Source: Saxo Bank
One possible trade
To take advantage of this bullish bounce, investors could use options on the underlying futures in a form of call spread. The strategy could look like this: Buy Oct 16 45 call for $1.76 / Sell Oct 16 47 call for $0.76.
The combined order produces a debit (money out of pocket) of $1. As this is a $2-wide spread, investors will have a 1:1 risk/reward ratio.
With 10 days to expiration, investors would have to manage this trade a little more actively and perhaps look for smaller gains, i.e. $0.80 per contract; alternatively, we could sell short puts.
Long volatility or long protective puts?
With volatility in the doldrums, what is one to do? Buy volatility or buy protection?
Let's start with looking at a protective put. A long put by itself is bearish strategy but when combined with a long underlying, it provides a hedge.
Suppose we own shares of Facebook. Since beginning of the year, shares are up over 20% and are trading near all-time high. The average true range, or ATR (a volatility measure), has a very low reading currently. You might say investors are confident.
If you are like me and confidently purchased the share near its all-time high, you might be exposing your portfolio to a huge risk should the market go south. Let's see what happens to your position when you add a protective put, such as the October 120 put paid $1.50...
Hedging your equity position or portfolio costs very little as volatility, which a big part of options premium, is low. For $1.50 or $150 we could ensure that a market correction does not make a big hole in our portfolio and set us back months or even years!
The protection could be rolled every 45 days if we were worried about market risks but didn't want to exit the market just yet.
For those that believe that volatility could expand going into September, you could look at various strategies – i.e. calendar and diagonal spreads – that would benefit should volatility increase on underlying stocks or indices.
Buying a straight call option on the CBOE VIX index, however, may be a little more risky than it seems, and here's why:
The current put-to-call ratio for the cash index is at 0.43, which suggests that there are 2.5 times more calls traded on the VIX that there are puts. From a contrarian view, this is still bullish equities and bearish VIX. Moreover, market participants have already bid up the prices for VIX call options in anticipation of a lift in volatility.
One way to get around this is through a call spread, i.e. long October 10 Call / short October 15 call. This will balance the position as you would buy a pricey option and sell another pricey option. Also, while the VIX is grinding between $11 and $14 you would still benefit due to the time decay in the short option.
Finally, traders could look at buying VXV6 (October delivery 44 DTE) futures for $16.28 and leg-in with VIX call options such as the 19 October 16 20 Calls and collect $1.05/contract. By doing this you'd avoid paying higher premium for VIX calls as you buying the underlying future.
As a reminder, VIX futures are 1,000 times the cash index. Therefore, if the underlying futures trades at $20 or your strike price, you would gain $3.72 x 1000 or $3,720 for every contract.
The VIX options have a multiplier of 100. Hence, for every one futures contract you would use 10 VIX options.
Have a great week ahead!
— Edited by Michael McKenna
Georgio Stoev is futures and options product manager at Saxo Bank