The following is a reprint of the market commentary from the February 2014 edition of The Option Advisor, published on Jan. 23. For more information or to subscribe to The Option Advisor, click here.
"A lot of people are getting ready for higher volatility..."
--Ryan Detrick, CMT, Senior Technical Strategist at Schaeffer's Investment Research, as quoted by Bloomberg and in the 1/18/14 edition of our Monday Morning Outlook
"Meanwhile, in the [CBOE Volatility Index] pit, paper sold Feb 13 puts to buy Feb 16 - 20 call spreads on the index, paying 14 cents, 110000X."
--Fred Ruffy, Trade-Alert, 1/9/14
At Schaeffer's Investment Research, much of the service we provide investors involves recommending specific trades on individual stocks involving the purchase of call options or put options (and, in the case of our much-revered Volatility Trader service, the purchase of call options AND put options in the form of a straddle trade).
And the backdrop for these options trades -- in terms of the general level of their "pay to play" price (also known as "implied volatility" in the options market) -- has rarely been more attractive.
For example, using the level of option premium as described by the 30-day implied volatility of options on the PowerShares QQQ Trust (QQQ) as a proxy for the cost to play equity call or put options, per the accompanying chart, this QQQ implied volatility has ranged over the past two years from a high of about 27% to a low of 11%, with current levels at about 13%. And since the level of implied volatility correlates just about directly with the premium levels for at-the-money options, it is fair to say that the breakeven hurdle for option buyers has rarely been more modest, and the leverage achieved by option buyers relative to the movement in the underlying stocks has rarely been higher.
So it makes perfect sense for intelligent speculators these days to be buying calls and puts in the current environment as a preferred means for capturing the price movement of stocks on which they have a strong directional view over defined time periods.
So far so good -- but when I take a closer look at what seems to be the ongoing trend in how those who trade options on the CBOE Volatility Index (VIX) go about their activities, logic seems to be turned on its head. And I'm thinking there may be a valuable lesson in this for all of us.
It is likely you are familiar with the VIX options. For one thing, the VIX options have consistently led all other option classes in trading volume for quite some time. And for another, those who buy VIX calls are betting on an increase in equity market volatility -- a bet that has been as extreme in its popularity in recent years as it has been unsuccessful in its outcome for those who've chosen to participate.
So with this in mind, let's simplify a bit what Fred Ruffy of Trade-Alert reported on Jan. 9 as headlined above, and say that a trader purchased a huge block of VIX February 16 calls , but he/she also sold the same quantity of VIX February 20 calls to create a bullish call spread. And if you are familiar with the dynamics of bullish call spreads, you know there are two major takeaways from this strategy:
So why -- in the wake of my preamble singing the very real virtues of plain vanilla option buying in January 2014 -- are VIX players instead buying bullish call spreads and truncating their profit potential?
The short answer is because volatility-based options are quite the different animal from price movement-based options, and in fact, volatility-based options are not so very cheap. But I much prefer the comments of my colleague, Todd Salamone, when it comes to assessing the motives of these VIX options traders:
"I see this type of (bullish call) spread in the VIX pits daily, and the popularity of this strategy reflects what I heard at the Options Industry Conference a couple years ago. Portfolio managers began whining about the cost of 'portfolio protection' programs (consisting of expensive VIX call options that regularly expired worthless). I think option strategists at brokerage firms have heard the portfolio managers to the point they've developed strategies (such as the bullish call spread) that I liken to protecting only the kitchen and risking the entire house burning down."
And to what does that great turn of phrase -- "protecting only the kitchen and risking the entire house burning down" -- translate in our world of options trading?
When you are buying VIX calls to help protect your stock portfolio in the event of a stock market crash -- during which the VIX may soar to 90, or 100, or even higher as investor fear turns to outright panic -- you may not want to readily cap your profits on your protection trade to the 20 area on the VIX. Or (as would be much more applicable to the vast majority of individual option traders), when equity option premium is priced at its current very reasonable level, you don't want to sell a further out-of-the-money option against an option you've purchased and thereby grant to another party all that sweet price movement that might occur beyond the strike price you've sold -- all in the interest of saving a couple of bucks at the outset.
Do you believe the stock you've been so closely tracking is ready to make an outsized move in a few weeks (or a perhaps few months)? Then consider buying a call (or a put), but make sure you buy enough time. But if your conviction isn't there, then don't torture out an options strategy to allegedly accommodate your lukewarm view. Save your money and wait for a legitimate opportunity for potentially multiplying it.
The Case for Big Moves in IWM and QQQ
Featured Partners: AOL DailyFinance
© 2015 Schaeffer's Investment Research, Inc. 5151 Pfeiffer Road, Suite 250, Cincinnati, Ohio 45242
Phone: (800) 448-2080 FAX: (513) 589-3810 Int'l Callers: (513) 589-3800 Email: firstname.lastname@example.org
All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.
Market Data provided by QuoteMedia.com | Data delayed 15-20 minutes unless otherwise indicated.