Nothing speaks volumes on this subject like this chart of the volatility index (click chart to enlarge), or VIX. Nicknamed the “fear index”, the VIX was designed to be a consistent, 30-day benchmark of expected market volatility (implied volatility), measured using At-the-Money S&P 500 index (SPX) option prices. You can clearly see below how volatility levels have been climbing steadily in recent weeks.
(If you’re not familiar with the VIX, you can brush up by checking out my previous posts on this topic. This post introduces the VIX; this more recent post summarizes my whole VIX series and provides links to more detailed info.)
As you can see above, for the VIX nowadays, 40 seems to be the new 30. That is to say, it used to be that the VIX rarely stayed above 30 for more than a few days at a time. In strong contrast, over the past month 30 has been the VIX’s new norm and 40 has become a regular occurrence. All this is telling us that option valuations have been extremely high.
As discussed many times in this blog, options and insurance products have surprisingly similar variables when it comes to determining their price – check out my post addressing the question, “Where Do Options Prices Come From?” for more on that. Think about how tough it’d be to buy homeowner’s insurance on your house last month if you happened to live on the Texas coastline. The ongoing financial markets crisis has created similar conditions for option contract prices across almost all stocks, but none more so than the banking sector. This has, in turn, raised the cost of speculation and hedging by buying puts and calls to all-time highs. What’s an aspiring options trader to do?
Let’s explore a cheaper way of getting into these trades – some call this the “buy now, pay later” strategy. (Quick word to the wise: none of these examples are meant to be recommendations, and my examples may not be suitable for all investors. Check with your investment professional and consider your own personal risk profile as you evaluate any investing strategy.)
Consider Goldman Sachs (GS), a financial stock trading at 134.50. GS’ ATM November option contract is currently trading around an implied volatility of 61%, double what it was last year. Let’s assume a bearish outlook on GS, as of 10/1/08 when I’m drafting this. Again, Goldman was at 134.50, and the November options had 51 days to expiration. The 115 put option (19.50 points OTM) contract was trading for $6.60 with an IV of 74%. Some might consider this expensive for an option with only 51 days remaining until expiration. As an alternative to buying the 115 put outright, you might consider putting on a volatility spread, which is really just an upside-down skip-strike butterfly.
Maybe that was a little fast for you. Let’s set this trade up, step-by-step:
- GS (Goldman Sachs) @ 134.50 with 51 days to expiration
- The P&L graph at expiration looks like this:
You can easily see from the graph why this trade’s nickname “buy now, pay later ” fits. Actually, it might be more accurate to call it a “buy now and maybe pay later”. If the stock went to the middle strike right at expiration, the total loss for the trade would be 5.84 – that’s what we might end up “paying” for the entire trade. Since the max loss is more than the debit paid, you should expect to hold additional margin on reserve. For this example, the additional margin required is the width of the first spread (130 – 125) . That’s 5 pts or $500 for each 1x2x1 volatility spread executed. Max Risk = 5 + .84 = 5.84
Max Gain = 5 - .84 = 4.16
Break-Even at Exp. = 120 (skipped strike) - .84 = 119.16
Additional margin $500 per 1x2x1 spread
This trade actually looks quite ugly at expiration. If the stock moves in the direction you want but not enough, that’s when you’ll encounter your max risk scenario. That’s why this trade comes to mind during especially volatile markets, because we need a big move to make the trade reach the maximum profit potential.
What if you’re wrong about the direction – in this example, if the stock goes up? That scenario puts your .84 cent net debit at risk, but that’s still less risk than if we just bought the 115 put outright – as of 10/1/08, that cost was a cool 6.60 per contract.
The upside is limited to 4.16 in the volatility spread, but that’s a classic tradeoff in the options world: lower risk usually means lower upside potential.
Let’s go back to the P&L chart for this trade. P&L-wise, this trade is definitely more interesting on day one of the trade as opposed to expiration. The red line of the graph below shows the P&L on day one. If the anticipated move happens right away, and assuming all variables are equal (no change in volatility, time to expiration, carry costs, etc.) the max loss would probably not occur when the stock went to 125. What that’s telling you is timing is very important to this type of strategy. Please make sure to study the strategy in the TradeKing Profit + Loss Calculator before putting it on.
A
few final points on planning this trade before you jump in. Given that this
example is 51 days from expiration, we might want to plan an exit based on time
– say, if the move does not happen within 30 to 40 days. You should also choose
a stop-loss point in advance based on valuation. If you’re bullish, use calls
with strikes ABOVE the current stock price; if you’re bearish, go for puts with
strikes BELOW the current stock price. Regards,
Brian Overby
TradeKing Options Guy
www.tradeking.com
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.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
Please be aware that early assignment of short options on American style expiration options may affect the overall max profit and loss potential of the strategy. Please plan accordingly for this possible occurrence.
TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. (c) TradeKing, Member FINRA, ISE and SIPC. http://www.tradeking.com?
