Article / 06 February 2017 at 14:19 GMT

Volatility Update: Volatility erosion persists — #SaxoStrats

Product Manager, Options Trader, Educator
Denmark
  • Volatility has hit rock-bottom with help from stronger corporate earnings
  • Investor sentiment improved slightly last week, but remains below historic average
  • VIX index has had prolonged periods of trading between $10 and mid-teens
  • Technically we could see range-bound VIX between $10-$12.50 and into teens
  • In range-bound market, remember to look at wide variety of products available
  • Range-bound market could support more momentum trading, aka 'scalping'
  • Volatility could be both sold and bought
  • Trade of the week: medical device maker Medtronic

Volatility abstract
 Volatility has dropped off sharply in the marketplace. Image: Shutterstock

By Georgio Stoev

Blame it on post-election results, stronger earnings from corporate America, strong US non-farm payrolls, and so forth —  volatility in the market is just barely present at the moment. There are still some earnings ahead of us which could spark some volatility in the market, but it's likely to be short-lived.

VIX at rock-bottom levels
VIX vs SPY
Source: Saxo Bank

Historic lows could stay for a while. Investor sentiment, as measured by the widely followed America Association of Individual Investors (AAII) weekly report, improved ever so slightly in the past week. Still, one could argue that the bullishness among retail investors is fairly low, at 32.8% against a historic average of 38.4%. In addition to relatively low bullish sentiment, an uptick up in bearish sentiment to 34.2% in the AAII survey could suggest that this rally is ready to turn.

Where does this leave us?

Our first webinar of 2017 with Dr. VIX himself, Russell Rhoads, indicated that the VIX volatility index has had prolonged periods where it traded between $10 and the mid-teens. As of the time writing, the fear index is trading at $11.50, which is its 30-day average price. Its 200-day moving average is $14. From a purely technical analysis viewpoint, this could suggest that we could see range-bound trading between $10-$12.50 in the foreseeable future and into the teens. Moves above $20 are far-fetched, but not to be ruled out altogether.

VIX long-term ranges
Long-term VIX
Source: OptionsLab webinar (CBOE Indices)


How to trade in low volatility?

We know an event like Brexit will inevitably happen again. A currency or commodity will run into turbulence, and the financial markets will react. How do we see the freight train coming?

For starters look at the various products and assets available. Saxo Bank prides itself on carrying over 30,000 products across many exchanges and time zones. Volatility can be traded through the underlying futures, (VXG7), through the options of the cash index (VIX) and dozens of exchange-traded products, exchange-traded notes and exchange-traded funds. 
 
Next, a range-bound market could support a little more momentum trading, or what old-school traders like myself call "scalping". Dips in the VIX below $11 could be bought, while bounces could be sold, using weekly expiration to keep costs low. Remember, though, with weeklies you only get one shot to make it or break it.

Lastly, volatility could be both sold and bought. When volatility in options has contracted, it could make sense to switch to buying options, for instance debit spreads, on equities, indices and so forth. Time spreads, such as calendar and diagonal spreads, could also work well as these will benefit from positive vega (volatility) and positive theta (time decay). So, if you look for the market to remain range-bound with volatility expanding here and there, these strategies or variations of them will support such a market view. As we have said earlier, the underlying futures can also be an alternative to trading VIX options.

Trade of the week: Medtronic

For the week ahead we see an extension of Friday's rally, with financial and healthcare stocks leading the pack. In the healthcare sector, we would watch closely shares of medical device maker Medtronic (MDT) as they sit at $76.34 and at a three-month resistance level. A break above could suggest further gains for the medical technology and service provider which could lead to a potential $5 move. 

For a bullish trade we would move here with a call spread involving a 17 MAR 17 75/77.50 call. As of Friday's close, the spread could be bought for $1.37 and potentially return $1.13 or 82% ROR. 

We would also watch shares of Apple as they seem to sit heavily nowadays. 


— Edited by John Acher

Georgio Stoev is futures and options product manager at Saxo Bank

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