Skip to main content

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.

Comments

Popular posts from this blog

FED Rate Hikes Could Cause Unintended Volatility Shock

Last week the Federal Open Market Committee surprised no one when they raised rates 0.25 basis points to increase rates to between 1% and 1.25%.  What did surprise the market, was the revelation that the FED is committed to normalize rates, even if inflation does not meet their target.  This was reiterated this week in a speech by William Dudley, President of the Federal Reserve Bank of New York, who stated he feels the FED needs to raise rates, despite low inflation, to be ready to act if the economy does slow down.
The market has been quick to respond, and nothing was hit harder by a reduction in inflation expectations than commodities.  Gold, since the announcement, is lower by 2.39%, and oil is down -3.18%.  Crude futures have broken their upward trend line and appear poised to test the previous low of $39.56.
While, oil has been under pressure all year, the S&P 500 does not seem to care, as it continues to make all-time highs.  Oil is down 23% year to date, while the S&P…

Gold and Treasuries Say “RISK OFF”, But VIX Says "RISK ON"

Today we are seeing a modest rebound in the market after yesterday’s small selloff.  Volatility remains extremely low, with the VIX hovering around 10.  It’s important for traders to recognize how low the VIX has been lately.  Since 2010, the VIX has only closed below 10 five times, and each of those five times has come in the last month.                   However, the market is not without risks right now.  Gold has rallied 6.5% since May 9th.  Treasuries have rallied, pushing rates to below 2.15.  So, the market is currently in a risk off mode while equities are in a period of historically low risk.  The VVIX (the VIX of the VIX), for its part, is not sounding the all clear signal, 87 is in the medium range for VIX volatility.  Tomorrow we have a potential market moving event with James Comey’s testimony to Congress.  The last time Comey’s name was in the news, we saw the VIX move from 10.5 to over 15 in one trading day (a 50% increase) on a day where the market was down over 2%.  …

Markets Soft without Stimulus

Markets around the world pulled back the reigns as central banks look to taper quantitative easing. Japan’s central bank decided to leave their current pace of monetary policy unchecked, which has effectively cut the Nikkei down 1.5% on the day, affecting nearly every market in-between, scaring the DJIA 165 points off the start this morning. US Treasuries have now notched the highest yield in 14 months on the 10 year note.

This morning 55,257 EEM July 35 puts were purchased by a trader for $0.29 each, costing him a large $1,602,453. This is a bearish move on the Emerging Markets ETF, with expectations that by the July expiration, the price of EEM will dip below $34.71. EEM opened today at $39.32 and if this trader was to pass the breakeven point, the ETF would have to drop by more than 11.7% within a little over a month.

EEM opened today 1.9% lower than its closing price yesterday and since the 52-week high the ETF experienced in early January, it has lowered by over 13%. While this …