Stocks quoted in this article:
Time to open up the (not terribly) voluminous viewer mailbag and answer some questions, some of which actually have to do with options.
And technically, it's not actually mail, or even email. These are just a few questions that I got asked on Twitter, which is a great way to ask questions, by the way. I'm @agwarner.
If VIX is a measure of put call buying why doesn't it go up on violent moves to the upside?
There's nothing to say it can't go up on violent upside moves, but we haven't seen that happen on any consistent basis since the late '90s tech bubble.
Remember that CBOE Volatility Index (VIX) measures implied volatility, which is part prediction of future volatility and part the price traders are willing to pay for portfolio insurance. A violent upside move pumps up realized volatility, and that does affect how the market prices implied volatility. But, the demand to protect portfolios generally decreases. No one's all that afraid of a super-fast move to the upside, plain and simple.
What's more, there's a natural headwind against VIX lifting in rallies. S&P 500 Index (SPX) options are skewed. The higher the strike, the lower the implied volatility. So, if SPX rallies, higher strikes with lower implied volatilities will comprise a larger part of the VIX calculation. Thus, VIX will dip on an SPX rally, even if the implied volatility of every individual option on the board stays the same.
On upward movements, it's often the drift that cause the problems (for premium sellers), not volatility.
OK, that's more statement than question. But, it's a statement I agree with.
Suppose SPX rallies 0.25% to 0.5% per day or so, without a range that extends much above or below that. That's going to come out to about an 8 volatility or so. If you can sell options at an implied volatility of 12, it sounds like a good deal, right? I mean, you theoretically will earn more in daily decay than you lose in price movement. And, it's so static that you probably won't bother to hedge your position much, if at all.
But here's the problem. Let's say you're short straddles or strangles. You're going to keep getting gradually shorter and shorter into rallies. In a day or two, it won't matter much, but eventually you're going to be just straight short -- and even though it's rallying very slowly, the net of the move cost you money.
Of course, you could take action at some point. The above assumes you just sell options premium and check back when the options expire. You could hedge your options' deltas every day, for example, and that would more or less lock in the advantage you generated by selling implied volatility at what turned into a good price vs. realized volatility.
Unfortunately, we don't know in advance what the market will do. If it has low volatility and just meanders in a range, you will cost yourself money with the constant hedging, Inaction was a better course.
It's always best when you sell implied vol. over whatever happens in realized vol. It's just not a guarantee of a winning trade.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.