Potential options strategies for the fiscal cliff

optionsguy posted on 12/27/12 at 11:01 AM

TradeKing Senior Options Analyst, Brian Overby, discusses potential option strategies for the looming fiscal cliff.

Surprisingly, the options marketplace - until recently - has been discounting fears of “fiscal cliff” fallout throughout the month of December. For the month the VIX – the so-called “fear index” of the market – was hanging out near the yearly lows of around 16.00. Meanwhile, the VVIX (or, the “VIX of the VIX”) touched a 52-week low of 77.21 on November 30th, and rarely broke through the 85 level during the month, also suggesting steady nerves. This implies that the near-term options on the SPX index and the VIX index were relatively “cheap” protections for most of the month.

However, now the fiscal cliff is looming and, even though the markets seem to be in stalemate mode waiting to for the cliffhanger to end, the VIX and the VVIX recently have jumped up over 19 and 90 respectively. If you are concerned about the potential cliff, there are some options strategies that may be able to save you some sleepless nights.

For individual stocks, the two most popular strategies against fiscal cliff fallout are the collar and the protective put. Both can be suitable strategies for beginner option traders, although investors should understand the trade before placing it.



You can learn more about this strategy on the options playbook site or by watching this 10 minute video, “Collar Option Strategy Can Limit Downside Risk”.



You can learn more about this strategy on the options playbook site or by watching this 10 minute video, “Buying Protective Puts to Reduce Risk”.

If an investor has a large portfolio and is seeking potential protection for their entire account, they could buy bear put spreads in an index that has similar stocks as their portfolio. To lower the total cost of this protection, one could buy options on that index across various prices levels. (“Protection” will be cheaper if you buy options that are more out-of-the-money than the index’s current value. The downside of that cheaper protection, of course, is that you’ll absorb more risk yourself. The risk from where the market is currently to the out-of-the-money put strike price will be your responsibility.) The question is, how many index put spreads should you buy for this kind of protection? Using the SPX as an example, one SPX put option will protect approximately $142,000 in portfolio value. (We calculate this by multiplying the current value of the SPX, 1420, by a multiplier of 100.)



You can learn more about this strategy in a previous blog post or by watching this 10 minute video,  “Bear Put Spread How to Video”.

Lastly, an investor could buy VIX calls if anticipating a short-term market panic. But VIX
options are not a standard option. The price of the option tracks the VIX future, not the actual index, so curious situations can arise when the VIX index soars but the VIX future doesn’t budge (or vice versa). Traders need to understand that how VIX call options work to trade them successfully, and it’s probably not a move novices can pull off.

You can learn more about this strategy in a previous blog post or by watching this 10 minute video, “VIX Options How to Video”.

If willing to learn about the VIX, an investor might buy some out-of-the-money VIX calls in the January expiration. We would be using the call options because the VIX usually has an inverse relationship to the SPX index – for example, if the SPX takes a plunge as a consequence of the fiscal cliff, VIX call options could rise in value, benefiting anyone holding VIX call options. The risk of the position would be the price paid for the call.

If you have any questions or would like more information on these strategies please just ask in the comment section below.

Regards,

Brian Overby

TradeKing Options Guy and Senior Option Analyst www.tradeking.com

Follow Brian on Twitter or visit TradeKing on Facebook and YouTube.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.

Online trading has inherent risks dues to system response and access times that may vary due to market conditions, system performance, and other factors. An investor should understand these and additional risks before trading.

Any examples used in are for illustrative purposes only — they should never be construed as recommendations or endorsements of any kind. No particular trading strategy, technique, method or approach discussed will guarantee profits, increased profits or provide minimization of losses. Past performance, whether actual or indicated by simulated historical tests, is no guarantee of future performance or success.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

At the time of publication and in the preceding month, TradeKing and/or Brian Overby did not have ownership greater than 1% in any stocks mentioned; did not have any other actual, material conflict of interest known at the time of publication; have not received compensation from a public offering nor from investment banking services related to any companies mentioned within the past 12 months, nor expect to receive any in the next 3 months; nor engaged in market making in the securities mentioned.

Futures data is supplied for educational purposes only; TradeKing does not currently support futures trading.

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Posted by optionsguy on 12/27/12 at 11:01 AM

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