Schaeffer's Trading Floor Blog

Getting Creative in a Low-Volatility Market

Is it worth it to walk the high-wire?

by 6/23/2014 7:45 AM
Stocks quoted in this article:

With the CBOE Volatility Index (VIX) hovering in the 10's, and realized volatility sometimes less than half that, what's one to do in options right now?

In theory, we'd naturally like to lock in that "cheap" volatility and just wait for the inevitable spike. But as we point out over and over again, it's just not that simple. If you're new to this story, here's the nickel version: You can't actually buy 10 volatility for any length of time in a VIX product, and if you buy actual S&P 500 Index (SPX) options at volatility here, you're actually overpaying relative to backwards-looking realized volatility.

But on the other hand, who wants to actually sell options now in any size? There's no margin of error for a blip up in Fear.

So, maybe it's time to get a little creative. A friend of mine who's in touch with order flow recently filled me in on what he's seeing:

We've actually stumbled on a client who sells wings nonstop ... usually strangles, but also 8-25 delta options in some of the higher flyers or relatively volatile industries (solar, 3-D etc). We do have people buying that stuff and I guess they turn and sell the meatier lines. They have cheap protection and a lot of these days are perpetually overpriced, so it's become a decent trade.

Now that's certainly a high-wire act, selling relatively cheap-dollar volatility in spots that actually move. You become the de facto insurance company. And if you're so inclined, where are you going to "write" policies? Strangles in the McDonald's Corporations (NYSE:MCD) of the world will net you next to no cash, so you have to find spots where you'll actually get paid. The big issue I see is the correlation between stocks and groups that may only share a bond of volatility.

Take the two industries he mentions above: solar and 3-D. News that impacts one group won't impact the other. But a general market allocation trend very well might. Think of the flight out of momentum in the spring or the flight into momentum most other times. A portfolio of strangle shorts in diverse names might not work as well as meets the eye at times.

But hey, that's the risk you take for getting the only place with good "reward" on the options street. I'm not saying it's a bad idea, just that it's maybe higher risk than it seems.

The more appealing side to me is the other one he mentions: buying the overpriced wings and selling the "meatier," closer strikes. Yes, it's essentially an iron condor, likely just not with an exactly even count on either side.

Specifics matter, of course, but generally speaking, you'd want the underlying to not move too much with this sort of position. Worst case is a move to one of the wings you own -- but remember, these are low-delta options, so that's a relatively improbable event. And it's very likely you don't have open-ended risk, like the straight strangle seller will.

So hey, if you're looking for something to do in this non-volatile market, selling some form of an iron condor in a more volatile spot sounds like a decent starting point.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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