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Morning Update

Since the election the Russell 200 is down 6.3% while RVX, an index that applies the VIX calculation to the Russell 2000 to track implied volatility, is up only 2.7%. Typically we would expect implied volatility to increase 4% for every 1% down move in the stock market, and the breakdown of this relationship suggests that there is no panic selling going on right now. Implied volatility has been kept low because option traders are selling puts into declines in the Russell as they choose levels they are willing to buy the market. Yesterday the largest trade of the day in RUT was a spread known as an iron condor. This spread involves selling an out of the money bull put spread and an out of the money bear call spread. This trader chose to sell 1602 Dec. 700/690 put spreads and sell 1244 Dec. 830/840 call spreads for a net credit of $1.15. At December expiration, which is in 34 days, RUT is between the spreads short strikes (700 and 830), all of the options will expire worthless and the trader will get to keep the credit collected. If RUT breaks out of the 690-840 range, either to the upside or downside, the spread will realize its maximum loss.

Traders sell iron condors when they believe the market will be range bound and that implied volatility overstates how much the market will actually move. Therefore iron condors are sensitive to changes in implied volatility and can be used to profit from a declining VIX, or in this case RVX.

But why bet on a decline in the RVX now? One reason is seasonality. Typically the December expiration cycle is a good time to short volatility because all of the exchange holidays and light trading volume mean there are fewer days for the market to make a big move. Another reason is that any good news, either of a Spanish bailout or progress on solving the fiscal cliff, will send this market higher and bring implied volatility crashing down.

By selling this particular spread, which has an exceptionally wide range where it can profit in, and market implied 88.50% chance of success, the trader demonstrating uncertainty about where the market will go and merely wants to collect some money by choose levels he or she is confident the market will not close above or below. While this spread has a high probability of making $1.15, it could lose as much as $8.85 if the market trends one way or another. Therefore traders planning to trade it must be prepared to hedge the position with stock or other options if the market moves against them, or size the position so that the maximum loss can be taken without too much pain.


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