Article / 28 November 2016 at 15:08 GMT

Volatility Update: The hunt for premium — #SaxoStrats

Product Manager, Options Trader, Educator
Denmark
  • VIX index reaches key 'crossroads' on Black Friday
  • Traders looking to sell volatility might consider bond yields
  • Opec meeting, nonfarm payrolls print key this week

By Georgio Stoev

As US equities extended their November gains for another week, the CBOE market sentiment index, or VIX, made its way back to the bottom of the barrel. The VIX settled at $12.34 on Black Friday in an abbreviated trading session. 

The low teens are levels considered by many traders as a crossroads, or a point where decisions need to be made. If you are a bull you should seek protection and if you are a bear, well, this is your time to start planning your trade. 

VIX Daily
Source: Saxo Bank

Besides just being near a technically low level, there are a few possible implications...

Lower VIX, lower expected movements

As a refresher, the volatility index measures the market's expectations. That is, market expectations as gauged by a range of 30-day options on the S&P 500 index. At the current level of 12.34, the expected annualised movement in the the cash index is up or down 12% at a confidence level of 68%, or one standard deviation. 

(To calculate the expected volatility range in a month we would take the current level of 12.34 and divide by the square root of 12  or 12.34/√12, or +/-3.57%.)

Lower expected movements, lower premium

All things being equal, lower volatility leads to lower value for options. Conversely, higher volatility translates to higher options premiums. At the moment, investors are less likely to sell call options on underlying stocks unless they see higher premiums. 

For instance, shares of Bank of America have rallied some 22% since the US election while at the same time the implied volatility on its options have declined to near the low range of its 30-day mean.

Volatility mean
Source: Dynamic Trend

What are options traders to do?

If you are looking to sell a covered call in an equity such as Bank of America, you might need to look further out in time. A shorter-dated option typically has lower implied volatility than a longer-dated one since time is more of a variable. 

If you do not want to cap your gains on some of these high-fliers, you should look to protect the gains by purchasing a protective put. 

As of Friday's close, the 16 December 20 put was priced at $0.22. 

Selling volatility

If you are like me and look to sell volatility, you should be looking at other markets where volatility has risen or is rising. The recent rally in equities has negatively impacted currencies relative to the USD. The rally has also hammered bonds prices as yields have surged. 

Implied versus realised volatility (TLT):
IV vs HV TLT

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Source: Dynamic Trend

With implied volatility near the high of the range currently at 16.33, traders could look to sell volatility through number of option strategies. The volatility of stock tends to trade within a range (gold dotted lines) and once that volatility comes out of the range, traders will look to buy or sell volatility. 

In the above example, IV moved above its 30-day range of 13.93/16.79 to trade at levels above 17. As volatility is reverting to the mean, it'd make sense to be selling options rather than buying. 

Selling strategies that are commonly used are short vertical spreads, short strangles and iron condors (for more on the latter strategy, take a look at this recent trade view).

Following up from last week...

For those who followed up on our trade ideas, we outlined two strategic trades and we still view these as very much current as the selloff in emerging markets is overdone and the seasonal demand for natural gas elevates. 

The diagonal spread consisting of March '17 35 call/January'17 38 call closed on Friday at $1.42 versus our cost basis of $1.32. 

We do not need to be reactive with this and will make a decision near the January expiration...

Natural gas continues its strength and as of the time of this post, NG futures (NGF7) are trading at $3.31. The movement in the underlying has given a great boost to our long vertical call spread. It is currently trading at $0.079/contract (multiplier of 10,000 units) or some 40% return. 

We will make a 50% reduction in the position and keep the rest. 

The week ahead

Earnings season has wrapped up, however, the economic calendar is full. Midweek, we have the Opec meeting which could move light crude either towards its recent high of $52.22/barrel or back towards $43/b. Investors could use a straddle going into the announcement or they could look at a double diagonal. 

(For the latter you could use the USO ETF, which tracks the underlying futures...)

The Chicago PMI release on November 30 as well as the weekly US EIA report will be scrutinised as well. The much-anticipated nonfarm payrolls report is due on Friday, and could prove the icing on the cake regarding the (also much-anticipating) Federal Reserve meeting on December 14.

New York City
Is the US finally on track for policy normalisation? Photo: iStock 

— Edited by Michael McKenna

Georgio Stoev is futures and options product manager at Saxo Bank 
2y
fxtime fxtime
Re: Bank Of America when considering selling a covered call strategy please remember also that they go ex div this week. (30th Nov)
2y
Georgio Stoev Georgio Stoev
Good point Fxtime. The options market typically has priced in regular dividends ahead of of ex-date. Unless an option is deep in the money, there is little to none economic benefit of a holder of an option to exercise, e.g. parity.
2y
fxtime fxtime
Very true about the options being fully priced but I meant expect the equity price to fall after ex div as asset managers re-allocate their short term portfolios and seek dividend(s) and eps elsewhere.

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