Article / 04 April 2016 at 14:44 GMT

Volatility Update: When fear is low, look out below

Product Manager, Options Trader, Educator
Denmark
  • Six-week rally has taken S&P 500 into positive territory
  • Real test for the index could come near 2,082 and 2,100 points
  • CBOE put-to-call ratio stands at 1, so investors hold puts and calls equally
  • VIX index has dropped another 11%, to levels seen last August just before big selloff
  • This suggests investors are fearful and greed is returning
  • Implied volatility on  S&P 500 has fallen, so options are fairly valued
  • With stocks near 52-week highs, this could be time to swap stocks with options
Aerial view of NYC
 Time to look out below. Photo: iStock


By Georgio Stoev

After horrible start of the year, markets have rallied for six consecutive weeks, sending the S&P 500 into positive terrritory, without even tapping on the breaks. Is this rally sustainable? What should we look for in first-quarter earnings? Find out below as we talk volatility, earnings and strategies.

First, a quick look at the markets year-to-date.

Markets
 








Equities, particularly in the US, continue to look bullish for the time being. But investor sentiment, measured by the Chicago Board Options Exchange put-to-call ratio, is unsupportive of either a bullish or bearish view at the moment. The ratio currently stands at 1, which indicates that investors are using as many call options as put options.

Technically, the S&P 500 also shows strength as the Relative Strength Index (RSI) continues to creep up. Any selloffs have been short-lived and have not had legs. The real test for the index, however, could come near 2,082 and 2,100 points. 

SPY Daily
Source: Saxo Bank 

The CBOE volatility index (VIX) — often called the "fear index" — has dropped another 11%, to $13.10, nearing the levels seen last August just before the seismic selloff, which is incontestably low. This suggests that investors are fearful and greed is returning. We could certainly follow the crowd and deploy some of our cash back into the market, but vigilantly and gradually. This is no time to get carried away. We have been near these levels of exuberance dozen of times since the last quarter of 2014.

VIX Daily
Source: Saxo Bank

The forward "skew" or "smirk" (instances where IV is lower with lower strike prices)  in the volatility illustrates that the premium for out-of-the-money calls and in-the-money puts is in greater demand. Moreover, the implied volatility on the S&P 500 has been falling, which suggests that options are fairly valued. 

Volatility smile e-mini S&P 500



















Earnings season and option strategies

US companies will start reporting first-quarter results this month, and according to Thomson Reuters, we should see a 7% drop from the Q1 2015 level. This could provide for some fireworks both positive and negative. For investors who are holding shares near 52-week highs, this could be time to swap stocks with options, to sell out of a stock and buy a call, instead. Most options are fairly valued at the moment, at least measured by IV alone.

Example: Sell shares of Tesla near $250 
  Buy June 250 call for $14.50

If the stock rises to $270, your calls should be worth at least $20. On the other hand, if the stock falls in the few weeks to $230, you would only be out the premium of $14.50, or $1,450, instead of $2,000. At that point, you could re-enter the stock at lower, more attractive levels. 

Option ideas for speculators

Traders who believe that an underlying stock could move significantly upon a binary event, such as earnings, could consider an options strategy called a straddle. A long straddle consists of a long call and a long put with the same strike price and expiration. Because an investor will pay for both options (call and put), to be profitable the stock price needs to move more than the premium paid. 

Example: Buy Facebook June 116 call/put for $12.40
For the above strategy to be profitable at expiry the stock price needs to rise above $128.40 ($116 +12.40) or go below $103.60. 

Stocks to watch: UA, AAPL, GS, VRX, ISRG

Have a prosperous trading week.



— Edited by John Acher

 
Georgio Stoev is futures and options product manager at Saxo Bank
  

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