What We Can Learn from Recent Volatility

In the last few weeks, we've seen the CBOE Volatility Index (VIX) pretty much double, and then halve. We've seen the markets implode (well, not really implode, but drop a bit) and then retrace to where we're only a few percentage points away from new highs.

There was a great trade riding the long side of volatility ETFs -- and then an even quicker great trade the other way. So, what's next? Well, I can't really tell you the direction. If I could tell anyone, I'd keep it to myself. Odds always favor the long-term trend persisting. Everyone loves to call major turns, but it's generally not the best strategy for actual investing.

In the options world, it's still an interesting backdrop. The VIX futures term structure is back to the good old days of expecting higher volatility tomorrow (click chart to enlarge):

What's noteworthy is that the nearer-term curve is pretty flat. That, of course, bodes well for the iPath S&P 500 VIX Short-Term Futures ETN (VXX), or at least un-bad. With no contango drag, it's a bit easier to hang with VIX moves.

Out in time, there's still premium. And, that extends to actual options, as well. This, from Steven Sears' The Striking Price column (subscription required):

While the S&P 500 rebounded quite nicely last week, at one point rising some 6% from the previous week's intraday low, its 90-day implied volatility is near two-year annual highs. This reflects anticipation of a sharp move. Unfortunately, volatility doesn't reveal direction, but every investor tends to have a view on what's ahead for his or her stocks.

Chris Jacobson, Susquehanna Financial Group's derivatives strategist, suggests taking advantage of options' heightened prices, which indicate widespread fear, by selling calls against positions. "For investors who believe a dramatic further move higher into year-end is unlikely, the increase in volatility can provide for attractive overwriting opportunities against an entire position, or a portion of a position," Jacobson recently advised clients.

I would totally agree. If you're of the mindset to sell inflated volatility, it's better to go further in time even, if it means you maybe get a lesser implied volatility than if you went nearer-term in the options.

Ultimately, the success of the trade isn't about the absolute price you get for the options. Rather, it's about whether the implied volatility you got was enough to compensate you for the realized volatility of the underlying. And, in the very near term, we're still in a bit of a volatility wave. Three months out, though? No way to know for sure, but it's likely volatility abates between now and then. I'd rather take that chance then try to guess right now when volatility tamps down.

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