Source: StreetSmart Edge
The start of 2016 was one of the worst on record for global equity markets as concerns over China, slowing global growth and the potential impact of either of these issues on the U.S. recovery sent investors out the exits. At one point the S&P 500 Index (SPX) was down over 11%, the Shanghai Composite Index was down 25% and the Nikkei was down over 21% year-to-date. Implied volatility shot up as a result of the heightened uncertainty and falling asset prices. The CBOE Volatility Index (VIX) has spent the majority of the year above the 20.00 level and is averaging 22.34 (through March 8th) versus just 16.67 in 2015. Markets have made a significant recovery since the February 11th low and volatility has subsided, but for how long? In this article we look at what you can expect from a volatile market environment and provide some trading considerations in the event that higher volatility returns.
Characteristics of a Volatile Market Environment
It should be noted that when you hear about a “volatile market” it typically means that asset prices are dropping, not rising. In other words, asset prices tend to move more gradually to the upside than to the downside. Another oft-stated trader maxim that conveys this is “markets take the stairs up but the elevator down”. What are some other characteristics that might be associated with a volatile market environment?
- Larger price swings. Uncertainty and emotions are typically elevated in a market sell-off which translates into bigger price movement, both on an intraday and closing price basis. In addition markets can be subject to large gap-ups or gap-downs due to overnight headline risk.
- A higher VIX. A rising S&P 500 Index (SPX) is generally associated with a declining or relatively low VIX while a falling SPX is associated with a rising VIX. Typically, the faster the SPX drops the quicker the VIX rises as uncertainty grows and demand for protection tends to push up implied volatility.
- More expensive option prices. Using the VIX as a proxy for overall market implied volatility you can typically expect to pay more for both calls and puts on indices, ETFs and individual stocks.
- Higher likelihood for volatility skew. The heightened uncertainty and bigger price swings typically sends the prices of out-of-the-money options higher as option sellers want to be compensated for the risk they are assuming. When implied volatility is higher on out-of-the-money or in-the-money options versus at-the-money options this is known as "skew".
How can we define a volatile market environment these days? This definition may vary depending on the time period, but I would say that from a recent perspective (over the last five years), when the VIX gets above 20.00 we are essentially in a volatile market environment. Of course not all volatile markets are the same, but all of the characteristics above should generally apply.
Trading Options in Volatile Market Environments
For option traders, higher volatility typically translates into bigger underlying price movements and more expensive options. This type of shift in the market environment can be difficult for inexperienced traders or for those who are slow to adjust their trading strategy. While individual risk tolerance and style may vary from trader to trader, here are some tips for option traders to consider:
- Sell options to offset high implied volatility (IV). If you buy long calls or puts you are going to find that prices are typically elevated in a high volatility environment. To help offset that higher cost as well as the negative impact of time decay, consider strategies that include both long and short options. Potential strategies include spreads (bull call spread, bear put spread, etc.), iron butterflies or iron condors. This can even apply to protective strategies such as a collar which includes both a short call and a long put.
- Try shorter expiration dates for credit generating option strategies. When implied volatility goes up you will typically see a smaller relative discrepancy between the prices of near-term and further-dated options. Therefore, you may notice that you can receive a higher credit (relative to the length of time until the option expires) by selecting a shorter expiration date. For example, you may find that a one-week put is bidding $2.00 while a two-week put is bidding $3.25 and may select the shorter expiration because of the higher relative price compared to the length of time. Types of “credit” strategies for consideration include covered calls, cash-secured equity puts and credit spreads (bear call spread, bull put spread).
- Try widening your spreads. Because the higher implied volatility tends to increase skew, it is not unusual to find a smaller price discrepancy between the strike prices on a given expiration. Therefore, you may want to at least calculate the cost along with the potential risk/reward for various strikes to see if a further out strike provides relative value. For example, you may find that a 100.00/110.00 bull call spread costs $6.00 to establish (with a $4.00 profit potential) but a 100.00/115.00 bull call spread costs $7.50 to establish (and has a $7.50 profit potential). A higher potential profit is always going to entail a higher cost but sometimes the trade-off becomes more favorable when you can put skew in your favor (i.e. sell a strike with a higher implied volatility than the one being purchased).
- Consider taking profits sooner. Volatile markets tend to be emotionally driven and run quickly in one direction only to reverse course the following day. Therefore, if you are sitting on a profitable trade you might want to consider booking those profits sooner than you normally would as the tide can change quickly.
- Consider reducing your position size. Since the underlying security tends to move faster in these types of environments you will most likely see your P&L (profit & loss) move quicker as a result. You may consider reducing the number of contracts that you typically might use on a given trade if you want to take some of the edge off the P&L gyrations.
- Be patient. This can be prudent advice for a trader in any market environment. It’s easy to get mesmerized by the larger price swings and potential profit but try not to force the trade – let the conditions for a high probability trade come to you. Be comfortable with the fact that you are probably going to miss some trade opportunities because of the higher scrutiny and you will probably feel more comfortable (and potentially more successful) with this approach. Remember, greater profit potential also means greater risk.
A dynamic trading strategy is important, especially in volatile market environments such as what we have experienced so far in 2016. Hopefully the guidelines presented above will provide you with a better understanding of what to expect and how to prepare accordingly.