Indicator of the Week: Does a Low VIX Mean It's Time to Buy Options?

Does a low CBOE Volatility Index (VIX) mean now is the time to buy stock options?

by Rocky White

Published on Aug 17, 2016 at 6:37 AM
Updated on Aug 17, 2016 at 8:05 AM

Last week I wrote about how the CBOE Volatility Index (VIX) was at extremely low levels. The VIX measures implied volatilities, or option prices on S&P 500 Index (SPX) options. It's telling us that option prices are extremely low on the broad-market index, or that traders are not expecting a lot of volatility going forward. Consequently, it takes a small move in the underlying index to get relatively big returns on options right now. So, is now the time to purchase options? This week, I'll take a look at how index options have performed over the past several years depending on how expensive (or cheap) option prices are.  

Methodology: For the analysis, I'm going to be focusing on the SPDR S&P 500 ETF (SPY) which is an exchange-traded fund (ETF) that tracks the S&P 500 Index. The options are very liquid with a lot of expiration dates available, so it's a good vehicle for an analysis like this. I will assume each day there was a call option and a put option available on the SPY that was exactly at-the-money (a strike is offered that matches the closing price of the SPY) and that expired in exactly 30 days. To get the prices of these theoretical options, I used actual implied volatilities on the SPY on those days at the expiration date closest to 30 days away. I assumed these options were held until expiration day and then closed out at intrinsic value. 

Once I had the implied volatilities, calculated theoretical option prices, and found returns of those options, I grouped the returns into six brackets based on the average implied volatility (average between the put and call). I'll start by looking at straddle returns, which is when you purchase both a call and a put option. The straddle can profit whether the index moves up or down; it's a bet solely on volatility. 

One theory I had going into this study was that traders would often underestimate the chance of a big move when the market became calm for an extended period of time, like now. That would lead to implied volatilities that are too low, and therefore straddle returns would do well going forward. The first chart shows that theory to be inaccurate.

Recall I said I grouped the straddle returns into six brackets depending on their implied volatilities. Each dot on the graph below represents each of those brackets. We are currently in the left most bracket, which is when implied volatilities are lowest. As you move to the right, the returns are for SPY straddles during times when implied volatilities are higher. I did this study using data since 2010, during which time the market has been quite calm. Also, option prices were based on closing ask prices, so the returns have generally been pretty negative.

You can see, though, the times when options are cheapest have not been good times to buy volatility. When options have been expensive (the right most bracket) has also not been a good time the buy straddles. According to this data, the best time to buy options on the SPY was when the average implied volatility was in the fourth bracket, the only bracket showing a positive average returns. That "sweet spot" was when the implied volatility ranged from about 14.5% to 16.5%. Currently, the average implied volatility is about 10%.

Average straddle CHART 1

With that first theory being wrong, a new theory could be that when the market enters periods of such low volatility there is essentially a floor of how cheap option prices can go. Option sellers can keep prices higher than their "true value" because portfolio managers, who use options to hedge their exposure, will always be there to demand the options, and accept the small losses to guard against major losses in the event of a crash. This is akin to how we are willing to accept "losses" on our home or vehicle insurance to guard against a ruinous loss. Anyway, that's just a theory to explain the poor performance of these options when they are supposedly at their cheapest. If this is in fact the case, then a savvy investor would be able to earn some profits by selling volatility. Careful though, because selling volatility can be a dangerous game. 

Finally, below is a table summarizing the straddle returns for each of the brackets (lowest implied volatilities at the top and highest at the bottom). As you can see, according to this data, which goes back to 2010, the proverbial "sweet spot" for buying volatility on the SPY was when the average implied volatilities was somewhere between 14.5% and 16.5% (the fourth bracket). The returns in the fifth bracket (16.5% to 20.5%) are also pretty respectable compared to the other brackets. We are currently well below these levels at around 10%. 

SPY returns CHART 2


Sign up now for a trial subscription of Schaeffer's Expiration Week Countdown! We'll send you 5 trades for expiration week, each targeting double- or triple-your-money gains in less than 5 days.


A Schaeffer's exclusive

6 Sectors for Summer

Access your FREE insider report before it's too late!


  
 

Partnercenter


NEW! Explore Schaeffer’s Partners' deals and get connected to top online brokerages with deals tailored exclusively for our readers.  Get answers to your questions regarding transfer fees, commission rates, programs and available discounts related to online trading services.

MORE | MARKETstories


The Next Big Player in U.S. MJ Boom
Most pure-play marijuana stocks in the U.S. trade on the Over-the-Counter stock exchange.
Wall Street Roars Higher Amid Civil Unrest
Investors weighed a mixed bag of jobs data
AstraZeneca Stock Flat Despite COVID-19 Vaccine News
AstraZeneca saw a rise in capacity for its COVID-19 vaccine candidate
The Next Big Player in U.S. MJ Boom
Most pure-play marijuana stocks in the U.S. trade on the Over-the-Counter stock exchange.