0.0
11.4
10.2
1235.0
11.1
10.1
1240.0
10.9
10.0
1245.0
10.7
9.9
1250.0
10.5
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some believe that it is due to the higher margin requirements for nakedput selling.For whatever reason, unlike a skew between puts and calls on ETFs,there is no way to profit from the reverse price skew through arbitrage. Inaddition, only large institutions that can trade all 500 S&P stocks can arbitrage the put and call skew on the SPX through conversion or reversal. Insum, the skews in the index market are not easily arbitraged away andgenerally represent a permanent condition.Traders can use this information to their advantage by understandingthat index calls will generally be cheaper than puts, and that options witha lower strike price will be more expensive than options with higherstrike prices. For instance, a call ratio backspread, which involves sellingcalls and buying a greater number of out-of-the-money calls, could potentially benefit from this type of skew.Conversion and ReversalA conversion involves buying stock, buying puts, and selling calls, whereboth the puts and the calls have the same terms. If an IV skew exists between the puts (low IV) and the calls (high IV), it can produce opportunities for a risk-free trade using a conversion. The position will have alocked-in proﬁt if the cost of the position is less than the strike price ofthe option. A reversal works the same way but involves short stock, shortputs, and long calls. Due to conversions and reversals, skews betweenputs and calls rarely exist. In other words, calls and puts at the samestrike price must trade at similar implied volatility levels.
IMPLIED VOLATILITY AND STRATEGY SELECTIONAn entire book can be written on strategy selection based on impliedvolatility in the options contract. One already has been! In The VolatilityCourse (New York: John Wiley & Sons, 2002), we provide a detailed discussion regarding what option strategies to use during high- and lowvolatility situations. The key point is that options with low IV are cheapand options with high IV are more expensive.Table 12.5 summarizes some of the strategies one might consider using in different situations. For example, if IV is low and the strategist isbullish, long calls and ratio backspreads make sense. These strategies willoffer better risk versus rewards if the strategist enters them when IV islow but expected to rise. If the strategist is neutral on direction of the underlying and implied volatility is low, long straddles and strangles make
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TABLE 12.5 Strategy Lists by Volatility EnvironmentImpliedVolatility
Low
Average
High
Bullish
Long callProtective putBull call spreadCall ratio backspread
Bull call spread
Bull put spreadCovered callNaked putCollarLong shares
Neutral
StraddleStrangle
StraddleStrangle
Short straddleShort strangleButterﬂy
Bearish
Long putShort stock, long callPut ratio backspreadStrangle
Bear put spread
Bear call spreadCovered putShort callShort shares
sense. Again, these positions involve the purchase of premium, a situationwhen it is better to buy low and sell high.When IV is high, the strategist wants to be more cautious about buying premium. For instance, if the strategist buys SPX puts when the VIX isat the high end of its recent range, there is a risk that (1) the market willstop falling, and (2) implied volatility will fall. The result is a doublewhammy to the long put from delta and vega. Instead, in a high-volatilityenvironment, the strategist might want to short an ETF or use spreads.Volatility skews can also open the door to trading opportunities. Forexample, calendar and diagonal spreads work well when the strategistidentifies significant time skews, with the short-term options experiencinghigher IV relative to the longer-term options. In that case, the short-term(expensive) options can be sold and the longer-term (cheap) options arepurchased. Finally, vertical (credit and debit) spreads can be used to takeadvantage of time skews.
ADDITIONAL VOLATILITY INDEXESIn addition to volatility skews, options traders watch for changes in implied volatility (IV) over time to determine if options are cheap or expensive on a historical basis. In addition, there are several tools for trackingthe changes in implied volatility throughout the index market. Thesevolatility indexes are benchmarks that are updated during the day likestock or index quotes.
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The Original Formula VIXOn September 22, 2003, the Chicago Board Options Exchange modifiedthe CBOE Volatility Index ($VIX). The ticker symbol for the modified index stayed the same, but the original VIX started trading under the symbol$VXO. The most significant change to the index was that, while the old index was based on the implied volatility of S&P 100 Index ($OEX) options,the new volatility index is derived from the more actively traded and liquid S&P 500 ($SPX) contract.The formula used to compute the VIX also changed at that time. It isno longer based on the Black-Scholes model, but on a slightly differentformula for computing expected volatility. It also uses a larger range ofoptions that are weighted to provide a more accurate measure of volatility. The time to expiration for these model options remained at 30 days.So, although the VIX was modified, the original volatility index construction continues to exist; hence, traders can use the $VXO to track the impliedvolatility priced into OEX options.
The NASDAQ Volatility IndexAfter the global financial crisis of 1998, technology was by far thestrongest sector of the stock market. From its low of 1,063 in October1998, the NASDAQ 100 Index (NDX) increased fourfold over the next 18months. As the index approached all-time highs near 5,000, technologywas the market’s hot sector, and most of the tech bellwethers were trading on the NASDAQ.The popularity of technology led many index traders to gravitate fromthe S&P 100 and S&P 500 Index to options on the NASDAQ 100 Index andsimilar indexes. In 1999, the AMEX started listing options on the NASDAQ100 Index Trust, or today’s QQQQ. Meanwhile, the CBOE, which had already listed options on the NDX, created the mini-NASDAQ 100 ($MNX, often pronounced “minx”), and MNX options started trading in August 2000.The MNX is almost exactly the same as the NDX, with one important difference: the mini-NASDAQ 100 Index is equal to 1/10 of the NASDAQ 100.Investors quickly embraced these two NASDAQ index products. Professionals turned to the QQQQ and MNX puts to hedge their growing exposure to technology stocks. Speculators traded the Qs and MNX on thebullish side.In response to the growing interest in NASDAQ 100 options, theCBOE launched an implied volatility indicator on the NDX in January2001. Known by its ticker symbol, VXN (sometimes called “vixen”), thenew IV indicator was created to track the IV of popular NDX options contracts. Like VIX, it is updated continually throughout the trading day.
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FIGURE 12.10 VXN and VIX (Source: www.ProﬁtSource.com)
There is a strong correlation between the VIX and VXN—they tend tomove together. Historically, VXN has been higher than VIX to reflect thegreater volatility within the technology sector, but the gap is starting tonarrow. Figure 12.10 shows the two indexes moving in a similar manner inrecent years. Both are in long-term declines.
The QQQQ Volatility IndexIf you trade the Qs, this volatility index is probably the best one to watch.Shortly after the CBOE created its NASDAQ volatility index, the AMEXalso recognized the need for an IV indicator. In fact, within days of thelaunch of VXN, the AMEX announced the debut of its own proprietary IVindicator: the QQQQ Volatility Index (QQV). This index, as you can imagine, is a composite measure of implied volatility on QQQQ options. LikeVIX, it is computed and available throughout the day.
The Dow Volatility IndexThe Chicago Board Options Exchange launched the CBOE Dow Jones Industrial Average Volatility Index ($VXD) in early 2005. Listed under the symbol VXD, the new index is “designed to reflect investors’ consensus view offuture (30-day) expected market volatility in the Dow Jones Industrial Average (DJIA),” according to a January 12, 2005, press release from the CBOE.*
*“The CBOE Creates Two New Indexes Based on the Dow Jones Industrial Average,” CBOE press release (www.cboe.com), January 12, 2005.
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The VXD is computed using the expected volatility priced into DowJones Industrial Index ($DJX) options. The DJX, you will recall, is a cashindex equal to 1/100 of the industrial average. So, just as the VIX is used togauge SPX options premiums, the VXD is used to track the volatility associated with options on the Dow. Traders looking for trading opportunitiesrelative to the DJX want to keep an eye on this volatility barometer.
SEASONAL TRENDS IN VOLATILITYSeasonal patterns exist with respect to volatility. Specifically, volatilitytends to fall during the summer months and again toward the end of theyear. The first few months of the year and the month of October tend toshow greater volatility. Table 12.6 shows the average reading from the VIXfrom 2000 to 2005. The average point move in October is 25.3, which is thehighest average of any month.Figure 12.11 shows the information in Table 12.6 graphically. Each barrepresents the average reading from the VIX from 2000 to 2005. The longterm trend is obvious. The volatility has been falling into a lower range,and this also reflects a decline in actual volatility (refer back to Table12.2). This long-term trend is obviously important to index traders because lower volatility will mean smaller moves in the S&P 500 index fromone day to the next.During the past six years, the NASDAQ Volatility Index has also beenTABLE 12.6 Average Moves in the CBOE Volatility Index ($VIX)2000
2001
2002
2003
2004
2005
Average
Jan
24.97
28.03
23.64
30.67
16.08
13.44
22.80
Feb
25.46
26.19
24.67
36.54
16.00
11.71
23.43
Mar
24.81
32.41
21.01
35.19
17.69
13.13
24.04
Apr
29.83
32.25
21.81
27.14
15.68
14.46
23.53
May
29.44
26.10
22.62
22.55
17.71
13.97
22.06
Jun
24.33
23.30
28.60
22.39
15.36
11.87
20.98
Jul
22.66
24.86
38.50
21.20
15.50
11.05
22.29
Aug
20.48
24.26
37.25
20.92
16.68
12.95
22.09
Sep
22.34
38.57
41.66
20.00
14.08
12.63
24.88
Oct
28.21
34.44
41.48
18.02
14.97
14.94
25.34
Nov
29.21
28.30
32.04
17.34
13.58
12.15
22.10
Dec
30.10
24.54
31.83
16.83
12.45
11.26
21.17
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FIGURE 12.11 Average VIX Reading by Month
moving into a lower range. For example, in December 2000, the averagedaily reading from the VXN was greater than 75. In December 2005, it wasonly 14.3 (see Table 12.7). The long-term decline in the VXN reflects thesharp drop in actual volatility on the NASDAQ Stock Market.Figure 12.12 graphs the information from Table 12.7. The decline inthe VXN is obvious. Occasionally, volatility on the NASDAQ will rise andTABLE 12.7 Average Moves in the NASDAQ Volatility Index ($VXN)2000
2001
2002
2003
2004
2005
Average
Jan
56.66
71.52
47.29
44.26
22.67
19.30
43.62
Feb
55.82
66.44
46.32
47.34
24.47
17.70
43.01
Mar
59.32
72.07
40.25
45.83
24.61
18.02
43.35
Apr
73.27
74.31
40.86
37.56
22.31
18.40
44.45
May
68.41
60.50
45.62
31.64
25.53
17.51
41.53
Jun
58.20
54.15
55.08
33.38
21.08
15.15
39.51
Jul
54.84
52.71
62.94
32.34
22.39
13.79
39.84
Aug
50.39
49.43
54.95
29.27
24.67
15.30
37.34
Sep
50.46
68.42
57.94
29.19
20.75
14.90
40.28
Oct
60.68
64.06
56.48
26.90
20.98
16.37
40.91
Nov
67.69
54.79
49.70
26.75
19.35
14.89
38.86
Dec
75.17
49.61
49.65
25.68
18.49
14.31
38.82
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FIGURE 12.12 Average VXN Values by Month
this will certainly affect option premiums. Nevertheless, the trend is clearand it could take many months or years for this pattern to change.
VOLATILITY AS A SENTIMENT INDICATORThe VIX has been dubbed the market’s “fear gauge” because it tends torise when investors become more anxious or nervous. Since the VIX is agauge of fear, it can also be used as a sentiment indicator. There is anadage among traders that “When VIX is high, it’s time to buy. When VIX islow, it’s time to go.”The philosophy underlying the adage is that when VIX is high, investors are relatively pessimistic and expect high levels of volatility going forward. At that time, the contrarian turns bullish on the market. It’stime to buy stocks. In contrast, when VIX is low, it is time to go (i.e., toget out of the market). The crowd is complacent and optimistic. From acontrarian approach, it is a poor time to buy stocks and, in fact, it’s “timeto go.” In short, high VIX means buy stocks (not options), but a low VIXurges caution.Unfortunately, VIX has not been very useful as a sentiment indicatorduring the past few years. It continues to set new lows but the S&P 500 Index is climbing. So just when it seems that VIX is low (and it’s therefore“time to go”), it falls even lower and stocks continue to rise.
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An important reason for the decline in VIX is the quiet performance ofthe market over the past few years. To illustrate, let’s consider the feargauge relative to the SPX statistical volatility. On the last day of trading in2005, the VIX was 12 percent—a low reading on a historical basis. At thesame time, the 20-day statistical volatility of the SPX was only 6 percent.Figure 12.13 shows the long-term decline in the S&P 500 Index’s statisticalvolatility, including the drop to new lows in December 2005.Although VIX was low on a historical basis in December 2005, it wasvery high relative to the actual volatility of the S&P 500 Index. Recallfrom Table 12.2 that the average daily move in the S&P 500 Index in December 2005 was only 4.3 points. So the market was trading very quietlyand SV was falling, but implied volatility was holding steady. The VIXwas double the S&P 500 Index’s actual volatility. The market’s fear gaugewas indicating that market volatility might pick up in early 2006, whichwould make sense since January starts a seasonally volatile period forthe stock market.When using VIX and other volatility indexes as a sentiment indicator,traders want to (1) consider its recent trading range, and (2) look for confirmation from the other sentiment tools discussed in Chapter 10. Creating a chart can help find the trading range. In 2005, the VIX stayed
FIGURE 12.13 S&P 500 Index Five-Year SV Chart (Source: www.Optionetics.comPlatinum)
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between 10 and 20 percent most of the time. When the market’s feargauge moves toward its extremes, then strategists can look at other indicators. For example, if VIX is low and the put-to-call ratios are similarlylow, the newsletter writers’ surveys are lopsided in favor of the bulls, theISEE is running higher, and everyone around you seems bullish, then itmight very well be time to go.
HEDGING WITH INDEX PUTSWhen VIX is low and it’s time to go, some investors might want to use index puts to hedge their portfolios. A hedge is a trade that reduces the riskof an existing position. The concept is not unique to options trading. Forinstance, farmers sometimes use the commodities markets to hedge theircrops. It is also possible to hedge an options position, a stock holding, anentire portfolio, event exposure such as rising interest rates, or a futurescontract.Reversion to the MeanAlthough volatility is always in a state of change, the volatility of stocks orindexes can be assigned a “normal” or average value. This is a value thatthe volatility of an index tends to center around throughout long periodsof time. In statistics, the average is also known as the mean. When volatility diverges greatly from that normal range, there is a tendency for it to revert back to that average, or mean. Therefore, if the volatility of an index islow relative to its average over a long period of time, there is a tendencyfor the volatility to increase and revert back to its mean. On the otherhand, when the volatility of a stock or index is high relative to its longterm average, chances are greater that it will fall back towards the mean.
Not all hedges are the same. There are the so-called perfect hedges,which remove all risk and partial hedges. Each is designed to limit the riskassociated with a given trading strategy. As an example, if I buy 200 sharesof SPY and one SPY put, I am only partially hedged, because one put willhedge only 100 shares.In the stock market, investors can hedge entire investment portfoliosof stocks with index options. For example, if an investor holds a portfolioof U.S. stocks, and the S&P 500 Index is trading at the 900 level, one putoption contract can be used to hedge a $90,000 portfolio (because the index multiplier is 100). However, unless the stocks in the portfolio are exactly the same as those included within the S&P 500, buying the put will
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not be a perfect hedge. Nevertheless, if there is a reasonable correlationbetween the stock portfolio and the S&P 500, buying index puts can offera partial hedge to many investment portfolio combinations.Similarly, a portfolio of NASDAQ stocks can be hedged using NASDAQ 100 ($NDX) or NASDAQ 100 Index Trust options (QQQQ). Other areas of the market can be hedged with various sector indexes (see Table12.8). If an investor is concerned about exposure to, for instance, energystocks, he might establish a partial hedge using puts on the Select SectorEnergy Fund (XLE). The goal is to find the index that fits the investor’sspecific needs at the time.Once the strategist has determined what underlying security to use,the next considerations are the strike price and the expiration date. Thematurity of the put option will depend on the time needed for protection.If the strategist wants to hedge a specific event, like an economic report,then short-term options will do the job. However, if the strategist is looking for a permanent hedge, he might want to look at options that expire inone year or more, and then roll the position forward well before expiration. Remember that options lose value at a faster rate when expirationapproaches. When time decay is a factor, it is better to hold longer-termrather than shorter-term options.What about strike price? If the SPX is trading near the 900 level, oneput option will protect a $90,000 portfolio. If the SPX 850 put is purchased,it will offer protection once the portfolio declines to $85,000 and any subsequent drop from that point forward. Keep in mind that the higher thestrike price, the greater the protection. However, puts with higher strikeprices will also have higher premiums. Therefore, the increased cost for
TABLE 12.8 Hedging Sectorswith SPDRsSelect Sector SPDR
Symbol
Energy
XLE
Consumer Staples
XLP
Health Care
XLV
Financials
XLF
Industrials
XLI
Utilities
XLU
Consumer Discretionary
XLY
Information Technology
XLK
Basic Materials
XLB
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the added protection will lower the total return of the portfolio, especiallyif stocks move higher and the protection doesn’t become a factor.Some hedgers are faced with a decision regarding over- or underinsurance. For example, if the portfolio is worth $100,000, one SPX 850 put willoffer only $85,000 of protection. This is $15,000 too low. Two puts will provide $170,000 worth of protection, or $70,000 too much. An alternative isto find an index that trades at a lower value. For example, the investormight consider the S&P 100 Index ($OEX) if it is trading near 500. In thatcase, two puts with a strike price of 500 could be purchased to hedge the$100,000 portfolio.Exchange-traded funds like the Dow Jones diamonds (DIA) or theQQQQ can also be used to hedge or partially hedge a stock portfolio. Thekey to successful hedging strategies with index options is first to findthose indexes that hold the stocks similar to the positions in the portfolio;and second, to identify the strike prices and expiration dates that bestmatch the objectives.When implied volatility is low, the cost of hedging a portfolio will becheaper than when implied volatility is high. Volatility is mean-reverting,however. This implies that when VIX falls to the lower end of its range, ittends to bounce higher. Therefore, the best time to establish the hedge iswhen VIX is low. Not only is this favorable from a contrarian perspective,but also because the low VIX indicates that implied volatility is low andtherefore the cost of the hedge will be cheaper.
CONCLUSIONFor many people, reading a chapter about volatility probably ranks rightup there with going to the dentist for a root canal. For serious optionstraders, however, it is a topic that should not be overlooked. Bottom line,volatility affects option prices directly, and in many cases dictates whichstrategy to use in different situations.First, however, volatility needs to be defined and measured. Volatilityis the speed of change of an investment. Direction is not a factor. Volatilitycan be high regardless of market direction—lower or higher.There are several ways to measure volatility. Historical or actualvolatility looks at price movement in the past and can be used to determine what is normal or average for the underlying index. Bar charts, average true range (ATR), and Bollinger bands can help view the actualvolatility of an asset. Statistical volatility (SV) is another measure of historical volatility that is expressed as a percentage; it can be directly compared to implied volatility (IV).
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Implied volatility, in turn, is one of the factors that determine an option’s price. When it is low, option premiums are relatively cheap. However, when IV is high, premiums are relatively expensive. Knowingwhether options are cheap or expensive can help dictate what strategiesto use in a given situation. For example, when VIX is low and S&P 500 Index option premiums are cheap, it may be a good time to buy index putsto hedge stock portfolios.
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MakingAdjustments
T
he fact that many market participants like to trade sectors or majorindexes to avoid company-specific risk has translated into opportunities for the options strategist that might not be found outside of theindex market. If you’ve ever been in a situation where you were rightabout the broader market direction, but the stock you chose didn’t movein tandem, then one or more of the index products discussed in this bookmight offer a strong alternative for you.Moreover, with the increased popularity of ETFs and HOLDRs, alltraders have the opportunity to use a wide range of products that reflect diverse markets such as interest rates, major oil companies, real estate, andbiotechnology stocks, as well as major market averages like the Dow Industrials and NASDAQ 100. Many of these same products serve as an underlying security for listed options—yet another benefit to the options strategist.Whether traders focus their efforts on delta neutral, volatility, ordirectional-based strategies, the ability to see and make adjustments to alter the original position is an empowering approach worthy of consideration—particularly when such an adjustment increases the reward-to-riskprofile. Using examples on some of the more actively traded ETFs, thischapter considers adjustments to modify and improve existing positions.
CONTRACT SPECIFICSThe popularity of exchange-traded funds has directly impacted the options markets in many of these products as well. Tighter spreads, more287
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liquidity in LEAPs, and strike prices such as those that are deep in-themoney are a few reasons to consider trading options on these relativelynew products. At the same time, some of these funds offer flexibility withstrike prices at just one-point increments. As we will see, the choice ofmany strike prices means that traders can initiate more dynamic andtailor-made positions. Some of the major index proxies that have this additional feature include the S&P 500 (SPY), Dow Industrials (DIA), Russell20