Playing Market Complacency With Volatility Option Spreads

By Chris Diodato

Just take a look at the VIX.  Any expectation of a panic has essentially subsided.  What does this mean for traders?  Index options, generally used for hedging, have zero demand, so option sellers are asking for very low prices.  We know that implied volatility is a mean reverting animal, so we would expect low volatility to move to high volatility in the future.  An increase in implied volatility would increase the value of all options, giving option holders an additional "expected volatility" profit.

 

How can we take advantage of this?  Capital intensive debit strategies.  At this point, not 100% certain of the short term direction of the market, I suggest using spreads and straddles.  These strategies profit from a large price move in the underlying.  As long as price moves, and moves far, the straddle or strangle holder will make money.  Therefore, the payoff looks like this.

 

 

From a traditional standpoint, there are several problems with this trade.  Let's use an October 2013 SPY 141 straddle for example.  SPY is currently trading slightly below 141.

  1. The S & P 500 would have to drop to around 1340 or climb to 1485 for us to break even!
  2. Time decay will give us a $5.50 loss every day, making us handle losses even if we are right!

The solution; stop making this a trade about price movement, and make it one about volatility.  Before even explaining, we need to make a commitment that we will not hold this trade until expiration, or even close to expiration.  For any expiration date, an increase in implied volatility to the levels in early May 2012 would give at least a 25% return on any of the at the money straddles.  So, assuming volatility will increase in the future, here's the trade.

  1. Options that expire in a long time will increase the most when implied volatility increase (VEGA).  Therefore, we should focus on a long-term straddle.
  2. Options that expire later also have less time decay in the short term.
  3. A good trade that avoids too high of a bid-ask spread while reaping these benefits seems to be the June 2013 SPY 141 straddle.

Here's the plan.  The cost of the trade is about $20.13 per share.  If price breaks to the upside, surging above the April highs, exit, since volatility will likely decline enough to offset any profits from the price movement.  Otherwise, our time stop is September 20 if it does not become profitable, which will give a maximum net loss around 7% (I chose those to fit within my risk parameters.  You may choose what suits you best).  The key is not to hold this trade for a long time, since theta will eventually eat away any profit or magnify any loss.

Profile photo of MetroTraderMetrotrader (D) is one of the few practicing CMTs (Chartered Market Technicians) in the United States . The CMT certifies his knowledge of market timing and risk management approaches. He tends to look for broad market moves and take advantage of them with index funds. The strategy he principally uses is mostly quantitative, and, tested, and has avoided or capitalized on every major recession since the 1940s. He says the best way to make money is to avoid losing it in the first place.

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