Schaeffer's Trading Floor Blog

Taking Advantage of Low Volatility

Should you swap stock ownership with long calls?

by 6/17/2014 7:15 AM
Stocks quoted in this article:

On the subject of the low, low CBOE Volatility Index (VIX), I bring you some thoughts via (the one and only) Steven Sears in this week's The Striking Price:

If nothing unexpected upsets the stock market's delicate balance at these lofty heights, says Krag "Buzz" Gregory, Goldman Sachs' equity-derivative strategist, VIX could fall to record lows. This is contrary to the popular view that a low VIX precedes a stock market correction because it indicates that investors are too complacent about stock prices.

If Gregory's view proves correct, options volatility will continue to decline. In this environment, some investors are taking advantage of a low VIX by rebalancing the risk of owning stocks. They are replacing some or all of their stock positions with bullish call options. Calls cost a fraction of the price of the associated stock, so less money is at risk.

I'm not so sure VIX will keep declining, but that's simply because there's really not much more it can do on the downside. We've already seen a 10 full. Even with realized volatility under 5, it's entirely possible we've seen the VIX just about bottom.

But I do think there's a good chance it hovers in this general area for a while, save for the randomly timed blips up that we see a few times a year. So I really do like his basic idea to replace stock with calls as a way to take advantage of the low volatility. Low volatility is a sign of complacency, but as we (and many others) have demonstrated, it's NOT a good bearish timing tool. It's more a reflection of the current trend than anything else, and trends are tough to buck. So the idea of switching from stock to calls makes perfect sense. It gives you a continued play on more upside, while limiting the downside should the Good Times stop rolling.

On a risk/reward basis, it's similar to just buying puts against your portfolio, the idea we mentioned yesterday. The premiums on the calls will eat into some upside gains you would have had by simply staying long in stocks. The advantage of just switching straight to calls is that it almost certainly gives you more efficient use of capital than having to carry both a put and stock position, even an offsetting one. The disadvantage is that selling a winning stock position might incur a tax bill, so obviously personal circumstances vary and should dictate strategy.

There's another implication of low volatility that we haven't touched on in a while. Whether you're an active trader or a more passive investor, it should influence your position sizing. The lower the volatility, the (relatively) larger you should play. You essentially get less bang for your trading/investing buck in a backdrop like this. And likewise, with the probability of a big downside move lower, you take on relatively less risk on a given position. Ergo, you would need to increase sizing to achieve the same effect as in a more "normal" volatility backdrop.

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

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