I got a few questions on what options positions should look like in a low vol environment like this. There’s a couple things going on with vol that I want to explain first.
The first thing to look at is the VIX, which is now trading about 16. Historically the VIX’s mean is about 19-20, so 16 represents a low vol environment historically but it can go lower. Much lower. The downward pressure on the VIX that we are seeing is due to a couple of factors. The first being that alot of the fears that gripped the markets the past year have now subsided, especially Europe and the risk of a double dip recession here in the U.S. The other factors are technical and mathematical.
Technically, the VIX will decline in a bull market run like we are having. This is for obvious reasons, fear of sudden drops in the market subside, people buy less protection etc. But there’s also mathematical reasons for the decline. The first of those reasons is that a market (or a stock) that moves roughly the same amount every day in the same direction will have a devastating effect on implied volatility because the actual volatility of an underlying that moves the same every day is next to zero. Translation: mathematically an underlying that moves 1% in the same direction every day is not really that different than an underlying that doesn’t move at all.
The best way to look at this is the actual volatility in the market (deviation of price of SPX) vs. the implied volatility (the pricing of option premium as represented by the VIX.)
Right now the VIX is slightly above 16, but the actual volatility of the SPX as represented by its 30 day historical volatility is a mere 9.5.
So what does that mean? It means in the near and recent term, options are too expensive for what the market is actually doing on a day to day basis. If you are long premium in the overall market, it is nearly impossible for you to be able to scalp enough stock on moves in the market to make up for the decay in premium in your long options.
The other factor to look at is the curve in the futures of the VIX. Right now the VIX futures are in a pretty steep contango as the front month futures trade around 18 with farther out months 22 and 24ish. This is pretty representative of the current environment as the front month reflects what’s going on in the market (nothing) and the back months represent what could happen (something?!)
So how do you trade this environment? Well, it’s tough. When I was an options market maker with a ton of positions in a large portfolio these were some of the most difficult times to make money. Ideally, what you would want your portfolio to look like would be short front month premium to try to to capture some decay against some long premium positions in the outer months that keep coming in vol wise. This is somewhat counter intuitive as you would be selling lower vol than your were buying, but it at least gives you a fighting chance of the front month options expiring worthless and the back months eventually getting some play with a more exciting market in the future.
But even this is no guarantee. Because you are shorting front month options at both low vol and low dollar amounts it doesn’t take much of a near term move before these options start costing you money. To make matters worse, there’s no guarantee that those farther out month options won’t keep coming in both vol wise and from premium decay as we move close to their expirations. If front month vol got so low and the contango so steep you may even want to reverse this position at some point and just fight like hell to scalp enough stock in the near term to fight the decay, and hope the back month’s contango curve lessened.
So to summarize, it’s not easy, but can be done. Some of the upcoming trades you’ll see on the site will reflect this thinking.