Last week in Know Your Options we took a look at how the CBOE Volatility Index (VIX) can be an important contrarian indicator of a looming change in investor sentiment, especially the way a steep rise in the prices of protective options often signals the end of significant market declines rather than continued volatility.
That definitely occurred again this time as Thursday’s strong rally of the major indexes was the fifth positive day for the markets out of the last six. As expected, options also got much cheaper on an implied volatility basis and the VIX is back in the 15% range – falling nearly 10% on Thursday morning alone.
As the legendary investor Warren Buffett is known for saying, “Be fearful when others are greedy and greedy when others are fearful.”
Now let’s take a look at the kind of options trades that will allow ordinary investors to be “greedy” in an intelligent way.
Over the past several years, the VIX has tended to return to low levels fairly quickly after spiking, providing an opportunity for traders to profit from “selling the rips” - either in VIX futures or in leveraged short VIX ETFs - and racking up apparently easy profits when the index returns to normal levels.
Despite anecdotal evidence of people quitting their day jobs and making six or seven figure incomes selling the VIX, this is not a sound strategy. It’s a classic example of what’s known as “picking up nickels in front of a steamroller.”
Successful traders all have a plan for mitigating risk. No matter how often you’re correct about anticipating a move in the price of any given security, you’re not going to accumulate any wealth in the long term if your losses have the potential to wipe you out.
Using the leverage of futures contracts or ETFs to sell the VIX is a trade that will eventually blow up in your face. You can make a few dollars by getting short when the index gets above 20% and waiting for it to return to lower levels, but when you’re wrong, you’re going to be very wrong – and watch helplessly as it quickly goes to 30%, 40% or occasionally even higher.
I believe that the multi-year trend we’ve seen toward lower average VIX levels is largely due to the fact that the options market making community has become increasingly more sophisticated and made the options markets much more efficient. The automation of trading algorithms means that the average investor can enter and exit options positions with unprecedented liquidity.
Most of the time...
Many market makers will either exit the markets (or make their quotations so wide that they have effectively exited) during periods of high volatility. In S&P Index options, this means that when the VIX gets elevated, the probability of another steep increase also rises. It’s a vicious cycle - higher implied volatilities further reduce the number of people who are willing to sell options and implied volatilities climb quickly.
When people trade (or stop trading) based on fear, it generally presents some sort of opportunity for those who are able to keep their wits about them.
The average investor usually has a diversified portfolio of large cap stocks and ETFs as well as a few more speculative small stocks. They stay pretty much constantly invested, enjoying the benefits of equity markets that trend higher over the long term and “gut out” periods of steep declines. If that’s what your holdings look like, the best trade during periods of high volatility is to sell calls on stocks that you own.
You essentially get to act the way that professional market makers wish they could trade if they weren’t precluded from doing so by the risk they’d already accumulated in a book of short options.
If you were planning to hold the stocks anyway, selling calls represents a way to generate extra income without adding any blowout risk.
If stocks continue to decline, you’re left with the same losses you would have suffered anyway in the portfolio – except those losses are smaller because you also get to keep the premium on the options you sold.
If stocks change course and rise in an orderly fashion, the implied volatility of the short options will decline and often you’ll enjoy not only price appreciation in the stock portfolio, but also profits in the declining option prices as well.
Anyone who’s ever bought a call as a bullish bet on a stock has probably had the experience of seeing the stock price rise, but also seeing the market price of the calls actually fall - even as the price of the underlying approaches the strike price.
It feels much better to be on the other side of that trade.
Finally, if equity prices reverse the trend and appreciate rapidly, the worst case scenario is that you sell some of your shares at the strike price – recognizing a profit – and you still get to keep the cash from the options premiums you collected. While this might leave you less fully invested than you might desire, having a big pile of cash in your account is never a disaster.
Remember, we’re trying to take all the relatively safe profits that we can, without any risk of losing everything.
Selling calls against your holdings when implied volatilities rise is one of the simplest ways to achieve that goal.
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