VIX and More

I am firmly of the Jim Cramer school of thinking that believes, “There is always a bull market somewhere.” Of course, with the advent of inverse exchange-traded products ETPs), you can turn just about any bear market upside down and transform it into a bull market...

With stocks stuck in a sideways drift for the last two months, the one corner of the financial markets that has been red hot has been corn. Since the beginning of June, corn futures are up more than 40%, rising from $5.51 per bushel to $7.73 per bushel. While institutional investors have been actively bidding up corn futures, most retail investors are likely to prefer the ETP route, where the Teucrium Commodity Trust Corn Fund ETF (CORN) is the only pure play on corn.

Back on July 5^th, with corn at $7.19 per bushel, I talked about the potential for corn to go parabolic when I observed:

“Extreme price moves are not uncommon, particularly when unusual weather patterns are involved…Note that while the June-July 2012 move in corn looks impressive, it pales in comparison to the spikes in corn prices that occurred in 1994-1996, 2005-2008 and 2010-2011. In other words, this could be just the beginning of a huge move in corn prices, particularly given that the price move of the last month or so comes on top of a much higher base.

Corn may be putting in a top soon, but a fat-tailed spike is not guaranteed to top out at the prior highs of $8.00 per bushel.”

Whether you are long or short – or have no position in CORN (or corn futures) – the current environment looks like an excellent time to think about CORN options. Traders who are long CORN are likely sitting on substantial gains and while some maybe be tempted to take some profits, the possibility of a breakout above $7.73 per bushel is just too attractive to part with that position. For this reason, longs may wish to consider the commodity/ETP version of a stock replacement strategy. Here the idea is to sell the CORN ETF, pocket the profits, and use a portion of those profits to buy some out-of-the-money CORN calls. With the CORN ETF closing at 49.85 today, the August 50s, 55s or even 60s might be a reasonable target. Should CORN reverse direction, a portion of the initial profits will be retained, but if there is another big bull leg, this options trade could turn a solid winner into the trade of the year.

Shorts might consider a similar limited risk approach. Rather than run the risk of continuing to be squeezed by a speculative buying frenzy, one strategy that makes sense is to close out any short CORN (or corn futures) position and buy some out-of-the-money puts. The August 45s and 46s are a popular choice, but there are some other excellent alternatives.

Finally, perhaps you have no desire to make a directional trade in corn and believe all the hype overstates the reality and prices are likely to remain a lot closer to their current level than spike again or plummet. Here a short strangles or straddles are sensible approaches, as are their limited risk counterparts, condors and butterflies.

If any of this sounds familiar, readers may recall that I made the argument for a similar strategic approach with silver at the height of the silver frenzy on April 27, 2011 in Is Volatility a Better Play for Silver Than Direction? With the benefit of hindsight, that post was published just two days after what turned out to be the intraday top in silver and two days before silver’s all-time closing high. I’m not saying the top in corn is here right now, but every day we get a little closer to that top and some of the options trades get a little less attractive.

Related posts:

• Recent Corn Rally in Context of Twenty Years of Corn Futures Prices
• Is Volatility a Better Play for Silver Than Direction?
• Straddles vs. Iron Butterflies
• The Options Opportunity Matrix
• World Food Sub-Index Prices
• Chart of the Week: World Food Prices
• Wheat and the Commodity ETF Space
• LSC Long-Short Commodities ETF Struggling Mightily
• Chart of the Week: Impact of Falling Euro on Stocks and Commodities
• Chart of the Week: Commodities and the Dollar
• Chart of the Week: Breaking Out Recent Commodities Moves
• CME to Use VIX Methodology for New Crude Oil, Corn, Soybean and Gold Volatility Indices
• Agricultural Commodities vs. Base Metals

[source(s): LivevolPro.com]

Disclosure(s): neutral position in CORN (via options) at time of writing

Right before the close last Wednesday I placed an ATM straddle that proved to be profitable and I closed it after the IV spike on Thursday. I shouldn't have come back for more, but I placed another ATM straddle Monday before the close and even with the huge drop in price on Tuesday the IV collapse only allowed me to break even. These were my first two super short term volatility trades and now I now that the free IV data on the CBOE's website is an end of day service... definitely wouldn't have placed that trade on Monday afternoon. Seeing now that I possibly should have been doing the opposite, shorting volatility, do you suggest any strategies that aren't outright short and don't require a big amount of margin to be put up? 

Also, what service do you use to view real-time IV for ETFs and such?

Adam C.

Hi Adam,

As a newbie, you should make an important distinction between options trades that have unlimited risk and those that you should characterize as limited risk or defined risk. Shorting 10 SLV July 47 calls theoretically opens you up to unlimited risk because SLV can continue to go up and up. Should this happen, depending upon your cash cushion, eventually your broker will hit you with a margin call and you will be forced to cover at a significant loss.

Take the same basic trade and add a second leg as a hedge and your unlimited risk is now limited. Instead of a naked short, a bear call spread involving 10 short SLV July 47 calls plus 10 long SLV July 50 calls caps your loss at the distance between the two strikes. Here that is 50-47 or three points. Three points times 10 options (with a 100 multiplier) puts your maximum loss at $3000.

Make that trade right now and for 10 contracts you should receive a credit of about $1.20 for that spread, so that means your maximum profit is $1200 and maximum loss is $3000 - $1200 or $1800.

This is a directional bet. For a non-directional bet – meaning that you expect SLV to be at about 47.00 at the time of the July expiration, you should probably focus on condors and butterflies, which are essentially the limited risk version of strangles and straddles. Sometimes you will hear a trader refer to “buying the wings.” What that means is they are converting an unlimited risk strangle or straddle into a limited risk condor or butterfly by buying out-of-the-money legs to hedge their risk, just as was the case with the call spread example above. As a matter of fact, one way to think about an iron condor is that it is just a bear call spread plus a bull put spread. Early on I used a more generic label of vertical credit spread on the blog for these strategies. You should be able to follow any of these links to get more information.

An even better way to get up to speed on these strategies is with some online resources. A good place to start is with the Options Industry Council (OIC), where they have an Options Strategy Index. Click on any strategy diagram for more information. Among the many great resources out there, I can highly recommend the CBOE’s Options Institute, where you might want to start with their tutorials. Keep in mind that the options brokers also do an excellent job of educating their customers on options strategies. Two that put a great deal of effort into education are optionsXpress (Education Center) and thinkorswim (Swim Lessons).

Also, the links below should provide some specific posts that will give you some food for thought regarding your recent SLV (?) trade and some alternative approaches.

In terms of real-time IV, I use Livevol Pro, which provides the graphs that I use on the blog for implied volatility and historical volatility. Your favorite options brokers (thinkorswim, optionsXpress, TradeMONSTER, Options House, Trade King, etc.) should also have good real-time or nearly real-time IV data. If you don't have an account at a broker that specializes in options, I highly recommend you open up one with at least one of the brokers mentioned above so you can get your data and place your trades on the same platform.

Related posts:

• Learning About Options (1) 
• Learning About Options:  The Exchanges (2)
• The Options Opportunity Matrix
• Selling Fear with a DryShips Bear Call Spread
• The Sideways Play
• Straddles vs. Iron Butterflies
• SPX Range-Bound Chart
• The Elusive Trading Range
• Strangle Pong
• Strangle Pong Update
• Strangle Pong Post-Mortem
• Pre-Geithner Financial Butterflies

It seems as if everyone in the world has an opinion about silver. Is it a bubble? Has it topped? Is it just consolidating before it goes to triple digits?

I have been trading silver directionally with a trend-following approach for many months, but recently exited all my long positions when I came to the decision that a top was imminent.

Still, silver looks way too attractive for me to sit on the sidelines, so now I am trading silver volatility instead of a directional play. The chart below from Livevol.com neatly illustrates my rationale.

Looking at the silver ETF, SLV, for the past six months, one cannot help but observe the ever-widening gap between implied volatility and historical volatility that has developed during the latter half of March. While it is certainly understandable that there is a great deal of uncertainty about the price of silver going forward, given the extreme recent volatility, I find it hard to believe that traders are betting silver will be about twice as volatile in the next month as it has been over the course of the last month.

For me this is a classic short volatility setup, with straddles, strangles, butterflies and condors looking to be pricing in an excessive amount of volatility. One need not necessarily structure those short volatility trades with the current price of SLV (about 44.18) at the midpoint of the spread. If one thinks silver has topped, why not sell a straddle at 43 or a strangle with a 40-45 spread? For now my focus is primarily a non-directional short volatility play, but one can also make a good case for a short volatility trade with a small directional twist, at least as I see it.

Of course, silver always presents some interesting pairs trading possibilities, typically with gold, but given the recent positive correlation between silver and stocks, an interesting approach is to look at short silver trades as a hedge for long equity positions.

Related posts:

• The Options Opportunity Matrix
• The Sideways Play
• Straddles vs. Iron Butterflies
• SPX Range-Bound Chart
• The Elusive Trading Range
• Strangle Pong
• Strangle Pong Update
• Strangle Pong Post-Mortem
• Pre-Geithner Financial Butterflies
  

Further to yesterday’s Leveraged ETFs, Volatility and Range-Bound Markets as well as my take on The Elusive Trading Range from mid-June, I thought I would share a chart I included in last week’s subscriber newsletter.

The chart below captures daily bars of the SPX going back six months. It includes Fibonacci retracement levels based on the April SPX high of 1219 and the July 1^st low of 1010. I have also added secondary support and resistance levels (black dotted lines) at 1065 and 1170 and have shaded the center of the Fibonacci zone (38.2% to 61.8%) in what looks like a salmon color (hey, it’s lunch time.) In addition to the SPX support and resistance lines, the study below the main chart is of the McClellan Summation Index (NYSI), a measure of market breadth, which shows more strength than has been reflected in just the recent price action.

My working hypothesis continues to be that we are in a trading zone that have been and will likely continue to be defined by some of the support and resistance levels on this chart. If this turns out to be the case, even with the VIX at what is now almost a three month low, straddles, strangles, butterflies and condors can still be attractive trades.

For more on related subjects, readers are encouraged to check out:

• Leveraged ETFs, Volatility and Range-Bound Markets
• The Elusive Trading Range
• The Sideways Play
• Sideways Markets, Covered Calls and the RUT
• Straddles vs. Iron Butterflies
  

Disclosure(s): none

I noticed that Direxion, the dean of triple ETFs, has added a handful of tools to their web site recently. These include:

• Daily/Cumulative Performance Illustrator
• Tracking Center
• Recent Volume Tool
• Volatility Tool
• Premium/Discount Tool

While all five of these tools (plus several more that are specific to Bloomberg users) are helpful for understanding how leveraged ETFs work and what to expect from them, the one that I am drawn to is the volatility tool, a snapshot of which is appended below.

If you are one of those investors who see the potential for range-bound trading in stocks and the possibility of entering The Elusive Trading Range, then straddles, strangles, butterflies and condors on leveraged ETFs are one way to capture greater premium than betting on a lack of movement in an unleveraged underlying.

Unfortunately the Direxion volatility tool is limited to 10, 30, 90 and 180-day volatility look back periods. Even more disappointing is that the source data are stale. Right now the volatility numbers are calculated on the basis of the June 30^th close. Using a good options broker or options data provider, one can build their own leveraged ETF watch list and get real-time implied volatility, etc., but kudos to Direxion for taking a small step to address some of the concerns that have been raised about leveraged ETFs in recent months.

For more on related subjects, readers are encouraged to check out:

• The Elusive Trading Range
• Sideways Markets, Covered Calls and the RUT
• Triple ETF Options Landscape One Month After New Margin Rules
• Using Options to Control Risk in Leveraged ETFs
• The Next Big Thing?

Disclosure(s): none

During the course of the last year or two, stock market pundits have reminded me a little of politicians in the sense that I have seen a dramatic increase in both the polarization of ideas and the stridency of the tone in which various points of view are presented. To some extent, the two are related and the bifurcation is understandable. Strong macroeconomic winds are blowing and the range of possible outcomes now seemingly includes quite a few more extreme scenarios than it did just a few years ago. The move toward a more decentralized media has also probably reinforced this trend.

When it comes to politics, the decline of the moderate thinker can be at least partly explained by the nature of the institutions and political processes that tend to herd voters into opposing camps. In the investment world, the shrinking of the centrist philosophy is more difficult to understand. After all, if two equally extreme scenarios each have the same probabilities associated with them, then the mathematical expectation is zero and represents no change at all.

All of this leads me to the chart below, which utilizes monthly bars in the S&P 500 index. Five strong trends jump out in this chart:

1. 1990s bull market, capped by the dotcom craze
2. 2000-2002 technology-led bear market
3. 2002-2007 rally, with easy money and the Greenspan put
4. 2007-2009 bear market, with real estate and financials leading the way down
5. 2009-2010 bouncing off the bottom

Based on the chart alone, investors can certainly be excused for being conditioned to expect stocks to trend strongly in one direction or the other. The truth is that we haven’t seen a good sideways market in a long time and investors just don’t expect a trading range to develop any more. The centrists have either slowly gone broke or have been banished to Extremia (just west of Siberia, if I recall correctly.)

Since nobody else is talking about a trading range, I thought I would stick my neck out and predict that SPX 666-1219 will likely define a trading range going forward, but perhaps more importantly, the tighter 1040-1219 range could also serve as a trading range for a surprisingly long period. Just because there are two large extremist camps doesn’t mean that both bulls and bears can’t be wrong.

If the markets do settle into a trading range, then options selling strategies are likely to perform well, particularly if high volatility persists. This means covered calls may soon be back in vogue, with more advanced traders looking at the likes of straddles, strangles, butterflies and condors.

For more on related subjects, readers are encouraged to check out:

• Sideways Markets, Covered Calls and the RUT
• One Approach for Volatile Sideways Markets
• The Value of Selling Covered Calls
• Can Selling Options Make You a Better Trader?
• The Options Opportunity Matrix

Disclosure(s): none

Like any stock index, from time to time the S&P 500 index seems to hand pick a number and make it an important support and resistance level. Sometimes these lines in the sand are ephemeral and sometimes they persist for extended periods.

Take SPX 1070, for instance. Back in October 2009, SPX 1070 was the exact midpoint in the SPX trading range I talked about in Strangle Pong and two subsequent posts (see links below.)

Since last Thursday, it seems as if SPX 1070 is starting to reassert itself once again. In the chart below, 1070 acts as critical support for awhile on February 4^th, then as resistance on the 8^th. Yesterday and today, 1070 was a pivot point of sorts, acting as both support and resistance. With 1070 just above today’s close and the futures currently pointing to a bullish start to tomorrow’s session, I will be watching closely to see how the SPX acts while crossing above or below the 1070 level.

For posts on the Strangle Pong and related subjects, readers are encouraged to check out:

• Strangle Pong
• Strangle Pong Update
• Strangle Pong Post-Mortem
• Round Number Magnet Strangle

Disclosures: neutral position in SPX via options at time or writing

[source: FreeStockCharts.com]

I had originally thought that I might begin 2010 with a series of articles on covered calls and other ways of using options to generate additional returns during sideways market action. Since several other writers have already jumped on this subject (notably Jeff Opdyke of the Wall Street Journal in Covered Calls Prove Popular Strategy; Mark Wolfinger of Options for Rookies in Writing Covered Calls in 2010; and Adam Warner of Options Zone in When Is the Best Time to Use a Buy-Write?) I am going to start slowly with these pointers above and a handful of links to previous posts below.

There is another point I wish to make. As of today’s close, the RVX, which is the volatility index for the Russell 2000 small cap index (RUT), is 33.8% higher than the VIX. As the chart below shows, this is at the high end of the range for the past year. Should volatility return to the markets, then I can certainly see how one might anticipate higher volatility in small caps than in the SPX. On the other hand, if stocks are going to continue to move sideways as they did today, then sellers of RUT options (straddles, strangles, iron condors, butterflies, etc.) should receive extra compensation for their short volatility positions.

For more on related subjects, readers are encouraged to check out:

• The Value of Selling Covered Calls
• The Often Overlooked Put Writing Strategy
• Unusual Chart of the Month: VXO and RVX
• One Approach for Volatile Sideways Markets
• BuyWrite Index as a Timing Tool?

[source: StockCharts]

Disclosure: none

When I first broached the idea of Strangle Pong (a strategy of selling a front month strangle in the SPX one leg at a time), I had every intention of periodically following up to offer comments on the strategy, how it was or was not working, and how a trader might manage a position like the one discussed in order to minimize risk while realizing a large amount of the profit potential.

In Strangle Pong Update, Mark Wolfinger (Options for Rookies) and I discussed the advisability of closing out the short put trade and taking some rather substantial profits. We agreed that keeping the position open in hopes of securing the final 3.65 in profit was not an attractive risk-reward play, particularly since the position had already earned 20.35 in profits. I concluded, however, that “for educational purposes I will opt to keep this an open item on the blog.” When I made that comment, I did not realize that an upcoming trip to Hawaii (the Big Island, where everyone who has an opportunity to do so should ignore the cost and take the helicopter tour of Kilauea) would keep me off the communications grid. What I am left with at this juncture is not the real-time analysis that I had hoped for, but a post-mortem. Usually I would not think a post-mortem would be as instructive, but in this case, I think there are quite a few lessons to learn.

For starters, while it turns out that my original rationale for the trade was rewarded at expiration, the risks along the way did not warrant holding through expiration, at least for me. This is an important point for beginning options traders, who have a tendency to hold their winning and losing options trades through expiration, usually resulting in winning trades giving back some of their earlier profits and all too often losing trades expiring worthless.

To recap, the idea behind the short strangle was to capitalize on the possibility of range-bound trading in the SPX in the 1040-1100 area during the last 16 days of the expiration cycle. The objective was to leg into the trade based on which end of the range the SPX was trading. The first leg was a short November SPX 1040 put that immediately went in the wrong direction. As the table below shows, the SPX broke 1040 and closed at 1036 and change (red shading) on the day the trade was initiated. With a maximum gain of 24 points, the trade was already a 5.45 point loss at the end of the first day. More importantly, a critical part of the trade thesis – that 1040 would provide support – was no longer valid. The bottom line is that there was very good reason to cut losses on day one and close out the trade.

As it turns out, my market timing signals earned their keep the next day as buyers jumped in, with support coming in the 1029-1030 area and the SPX beginning an almost uninterrupted bullish run for the next 13 trading days. After 5-6 days, the SPX had recovered to the middle of the target 1040-1100 trading range (blue shading) and two thirds of the potential profit had already been realized.

The week prior to expiration saw the SPX take a run at 1100 and just fall short. During that week, the 1040 puts fell all the way down to 1.40, while the November 1100 calls moved up in price on Monday and Wednesday (bold blue type). The short 1100 call position that Mark and I discarded as too risky on Monday at 8.40 would have been a loser from Monday through Thursday. While the short 1100 call eventually became profitable on Friday, the following week the SPX broke out over 1100 and closed near 1110 on Monday, Tuesday and Wednesday, with the calls still unprofitable and threatening to incur larger losses.

Getting back to the original rationale for the trade, once the SPX closed above 1100 on Monday, upside resistance was broken and the risk was too high for a relatively small reward. At that stage – and with only four days remaining prior to expiration, I would have closed the trade at a loss of 3.20.

So to recap, while this looks like a perfect short strangle on paper, with both the short put and the short call expiring worthless, prudent risk management would not have resulted in holding the trade until expiration. Further, not only would the profits on the short put have been taken early (netting 20.35 out of a possible 24.00), but if the short call leg had been initiated (and I thought this was a questionable trade at the time of the Strangle Pong Update), I would certainly have cut my losses (-3.20) before giving the trade a chance to make a profit.

The bottom line is that this was a great trade on paper, but with proper risk management, is was merely a very good trade in terms of profits, netting only about 60% of what would have been earned if the strangle had been held to expiration. Over the long run, however, I maintain that understanding the risk-reward profiles of existing options positions is more important than trying to extract the maximum profit from each options trade.

For the two previous posts in this series, readers are encouraged to check out:

• Strangle Pong
• Strangle Pong Update

On October 30^th, in Strangle Pong, I talked about the possibility of legging into an S&P 500 index strangle, starting with the sale of a November SPX 1040 put and looking to sell a November SPX 1100 call when the index rallied back over 1080.

Here we are six trading days later and the SPX November 1040 put, which was at about 24.00 at the time of my original post has fallen back to under 4.00 as I type this.

The table to the right shows the closing values for the 1040 put (SPQWH) and 1100 call (SPTKT) since I originally mentioned the strangle (the values for today are the midpoints between the bid and ask as of 1:00 p.m. ET.) The table shows that the both the bounce in the SPX (from 1043 to 1086) and the substantial drop in the VIX (from about 28 to 23) have significantly eroded the value of the 1040 put. Interestingly, the increase in value in the 1100 call is nowhere near as dramatic as the movement of the puts, as time decay has neutralized some of the gains that were realized by an increase in the underlying.

Frankly, this would be an excellent time to close out the short put position and pocket a nice profit. Sticking to the original line of thinking, however, a trader could let the short put run and short the 1100 calls to open up the other leg of the strangle. The risk-reward is not as attractive as it was for the short put, but assuming (and this is perhaps the most important assumption here) that 1100 continues to serve as upside resistance, pocketing 8.40 for the call is an attractive opportunity.

Note that this strangle is not hedged in any way. As noted previously, once can limit risk in a strangle by “buying the wings” (offsetting long put positions below SPX 1040 and offsetting long call positions above 1100) and converting this position into an iron condor.

For related posts, readers are encouraged to check out:

• Strangle Pong
• VIX Defining a Range Between 22 and 30
• Round Number Magnet Strangle

While this might not provide a great deal of comfort to longs, I have updated the VIX and More Pullback Table to reflect today’s selloff. The table shows that the peak to trough drop of 67.98 points (6.2%) in the SPX has exceeded the 2009 average of 5.8%.

As noted previously, a 5.8% pullback from the SPX 1101 established a target low of 1037. Today the SPX has been as low as 1033.38.

Looking at the charts, I would expect to see additional support in the 1015-1020 level should the 1034 mark fail to hold. In the meantime, brave souls who heed the VIX spike history or the strangle pong strategy should have a long bias going forward.

For related posts, readers are encouraged to check out:

• Does the Pullback Have Legs?
• Pullbacks in the 2009 Bull Market

[Edit: data updated as of 3:10 ET]

For the moment at least, it appears as if the S&P 500 index has encountered strong resistance at 1100 and strong support just above 1040. Assuming these support and resistance levels can hold up for another three weeks – and that is admittedly a large assumption – then the current market environment sets up nicely for what I like to call “strangle pong” with November SPX options. Essentially, this is an approach where one assumes range-bound trading and sells near-the-money options when the underlying approaches one end or the other of the trading range.

The graphic below outlines one way to approach this type of trade. Specifically, it involves dividing the trading range into three zones (which do not have to be of equal size, they just happen to be in the diagram): an upper end of the trading range in which one sells calls; a lower end of the trading range in which one sells puts; and a neutral zone near the middle of the range in which one takes no action (or perhaps sells both puts and calls.)

In an ideal world, the underlying bounces back and forth between support and resistance just like the pioneering computer game and the options seller captures a high premium each time the underlying approaches the end of the range. Once both puts and calls have been sold, a strangle is established, with the maximum profit and loss zone being defined by the target trading range.

The most important determinant of success in a strangle pong trade is the trading range of the underlying during the life of the trade. Of secondary importance is the volatility of the underlying, where increased volatility will increase the price of the options sold and work against the options seller. This is a position’s vega and is something I will address in future posts.

There are a number of ways on which position risk can be managed, not the least of which is to “buy the wings” (offsetting long put positions below SPX 1040 and offsetting long call positions above 1100) and convert this position into an iron condor. According to the strangle pong approach, right now, with the SPX trading a little below 1050, would be a good time to initiate the first leg of this trade by shorting some SPX 1040 puts. Let’s see how the market moves in the next week or so; I will revisit this strangle pong trading approach at that time.

For additional posts on strangles, readers are encouraged to check out:

• VIX Defining a Range Between 22 and 30
• Round Number Magnet Strangle
• ETFs, Leverage and Strangles

With some very important earnings in the financial sector coming up this week (JPM on Wednesday; C and GS on Thursday; BAC and GE on Friday), I have been watching implied volatility (IV) in the sector very closely. Much to my surprise, implied volatility has not increased ahead of earnings, as is typically the case.

The chart below, courtesy of Livevol, shows six months of price and volatility activity in JPMorgan Chase (JPM), with the upper portion chart highlighting the last two earnings releases with the blue “E” icon. The bottom half of the chart plots 30-day implied volatility (red line) against 30-day historical volatility (light blue line) during the same period.

Note that just prior to the last two earnings reports, implied volatility rose due to the uncertainty and potential for higher volatility associated with an earnings surprise. This time around, however, the lack of movement in implied volatility – as well as the proximity of the IV level to historical volatility – suggests that investors are not expecting any surprises at all. In fact, this situation is not specific to JPMorgan, but is also mirrored at Citigroup, Bank of America, Goldman Sachs and even quasi-financial General Electric. Not surprisingly, the bank ETFs, such as KBE, and the financial sector ETF, XLF, show a similar pattern.

No matter how the current earnings season unfolds, it is difficult to imagine that there will not be any surprises. Investors who think implied volatility is underestimating the surprise potential for the banks may look to initiate long straddles or long strangles to take advantage of a potential increase in implied volatility – and hence options prices.

For some related posts on implied volatility in financials, readers are encouraged to check out:

• Implied Volatility of 19 Large Financial Institutions: Now vs. 52 Week Highs
• FAS Is Now XLF
• Are FAS Options Cheap with an Implied Volatility of 232?

[source: Livevol Pro]

The CBOE Volatility Index, which is usually referenced here by its ticker symbol, VIX, seems to be settling comfortably into a range between 22.00 and 30.00 that is has traded in since early July. Given that the relatively narrow eight point range has now held up for three months, there is a natural tendency to wonder whether the VIX has started to form a natural top and bottom that will result in an extended stay in this range.

The chart below tracks the daily movements in the VIX back to August 2008 and shows how the gravitational forces working on the VIX have pulled it back from just shy of 90 to the low to middle 20s. This is still above the 19.00 – 22.50 range that prevailed in August 2008, but not by a large margin.

Even with all the uncertainties surrounding the upcoming earnings season – which Alcoa (AA) technically kicks off after tomorrow’s close – I still think there is a strong probability that the VIX spends the balance of the year in the same range that it has been during the past three months. In fact, with earnings next week from the likes of General Electric (GE), Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), Goldman Sachs (GS), Intel (INTC), International Business Machines (IBM), Johnson & Johnson (JNJ), CSX and others, I expect the tone for the balance of the year to be established in another 2-3 weeks, at most.

As volatility tends to escalate prior to earnings, there is a strong temptation sell some options – including VIX strangles – before the third quarter results start pouring in. I will have more on some VIX short strangle trading ideas in short order.

[source: StockCharts]

The power of round numbers does not seem to receive a lot of play in investment circles. Sure, there is the psychological significance of an index or a stock crossing above or below a round number, but I am surprised that nobody ever talks about how to trade these.

Rather than look as round numbers as potential areas of enhanced support or resistance, I like to think of them has having a strong attractive power, almost as if they are large magnets. In some indices and stocks, prices tend to linger near round numbers for longer periods than a random distribution would suggest.

One way to take advantage of the attractive tendencies of round numbers is to sell options at or near that strike. Straddles, strangles, butterflies and iron condors would certainly be appropriate choices, but I have personal preference for strangles, with their wide maximum profit zone and simple construction/position management.

These ‘magnet straddle’ plays can utilize options of any duration, but maximum time decay (theta) is achieved in the last few weeks prior to expiration. In the graphic below, which is courtesy of optionsXpress, I show that anyone interested in selling an 890-910 strangle on the SPX can make a profit if the index manages to stay in a 40 point zone (880-920) during the last three days prior to expiration.

I feel obliged to mention that conventional wisdom says expiration week is too fraught with short-term uncertainty and gamma risk to be traded profitably on a consistent basis, yet I still think there are a number of opportunities where probabilities favor the experienced options trader.

Finally, if this trade sounds somewhat familiar, readers may be interested in checking out a similar straddle trade in Is the SPX Going to Stick Close to 900? from last December. With a VIX in the upper 50s when the original trade was discussed, the profit zone of 840-960 makes it look like a slam dunk winner by current volatility standards.

[graphic: optionsXpress]

I was surprised by the volume of the feedback I received from last week’s Using Options to Control Risk in Leveraged ETFs. Clearly there is a great deal of interest in options and leveraged ETFs.

Among the emails I received were several questions about strategies associated with ETFs. For the record, my intent here is not to advocate a particular strategy, but merely to illuminate various strategic building blocks that I believe should be part of the trading arsenal of any options trader.

With that out of the way, let me spend a minute talking about strangles. I realize I have not talked about strangles as much as straddles here, but I actually prefer to trade strangles instead of straddles when I am selling options. Whereas, the point of maximum profit for a straddle is a point that often resembles a Sisyphean lottery, strangles have a maximum profit zone that is much wider and easier to manage.

In the chart immediately below, I have taken a snapshot of a short strangle on IWM, which is an ETF for the Russell 2000 small cap index. The short strangle is created by selling 10 June 50 puts and selling 10 June 55 calls. In this example, the puts have an implied volatility of 37 and the calls have an implied volatility of 31. Note that the maximum profit on this short strangle is $1210 and occurs if IWM closes anywhere from 50 to 55 at expiration. The full profit zone spans 7.92 points from 48.79 to 56.71.

TNA is a 3x ETF for the same Russell 2000 small cap index. Whereas IWM closed at 52.43, TNA closed at 30.66, a little more than 41% below its 1x sibling. Even at a significantly lower price, however, the firepower of the 3x ETF is immediately obvious when you look at the options. The chart below shows the result that is created by selling 10 June 28 puts and selling 10 June 33 calls. As in the IWM example, the strikes have a five point interval. The differences in the profit and loss graphic below are largely a result of the extreme differences in volatility. In this example, the puts have an implied volatility of 92 and the calls have an implied volatility of 87 – almost, but not quite, three times that of IWM. As result of the higher volatility, the maximum profit is $2800 (between 28 and 33), while the full profit zone is 10.60 points, from 25.20 to 35.80.

In brief, for an implied volatility that is about 2.6 times higher, TNA offers a maximum profit that is 2.3 times greater and profit zone that is 1.3 times larger.

These comparisons are admittedly less than perfect, given that the IWM and TNA trade at much different prices, but they certainly convey the essence of the idea that in a range-bound market, an options seller who is short options on 3x leveraged ETFs can rack up large gains (or losses) in a hurry. Of course, this same trade can be made much less risky by "buying the wings" and turning the strangle into an iron condor.

For a related post, check out The Options Opportunity Matrix.

[graphics: optionsXpress]

After receiving several questions and comments regarding yesterday’s VIX Expiration Straddles and a related prior post, A VIX Butterfly Play, I realize that I skirted a fundamental options issue that I should probably have placed more emphasis on: unlimited vs. limited risk.

The issue centers around a key concept in trading options: is the maximum loss on a position limited? In other words, at the time the position is opened, is it possible to define, in dollar terms, the maximum loss and the price points at which this loss will occur?

The question can also be addressed in graphical form.

In the profit and loss graph below, courtesy of optionsXpress, I have replicated a trade that is similar to the straddle trade highlighted in VIX Expiration Straddles, except that it uses May options.

If the trade has unlimited risk, such as is the case with the short straddle below, the profit and loss graph will show diagonal lines at the extreme left and right side of the x-axis.

By contrast, it is possible to augment a short straddle position by buying insurance to protect against unlimited losses in the form of an equal amount of long calls (known in some circles as “buying the wings.”) The result is an iron butterfly, with the “wings” limiting losses.

The graphic below shows the same trade as the short straddle above, but with the additional purchase of out of the money puts and calls. Notice how the new wings are the horizontal lines that reflect limited losses of $440 in this position.

The wings are particularly important in the event of extreme moves. In the short straddle, every dollar move in the VIX above 45 results in an additional $1000 loss. The iron butterfly, however, limits losses at 40, so the VIX can spike as much as it wishes over 40 without impacting the bottom line. The same dynamics are at work were the VIX to plunge dramatically.

Note also the cost of the insurance will reduce the maximum potential profit (which falls from $5510 to $2060) by 63% and also shrink the price range in which the trade is profitable (from 31.99 – 43.01 to 35.44 – 39.56) by the same 63%.

It may be helpful to think of the cost of buying the wings as the price of insurance to limit risk. Most traders prefer to pay the insurance premium and sleep better at night, but there are those who prefer to forego the wings and hope to avoid a disaster. This type of approach can be effective in the short-term, but over the long haul is an excellent way to lose all your trading capital.

For the record, the same relationship described above with respect to straddles and butterflies is analogous to the relationship between strangles and condors.

[graphics: optionsXpress]

Maybe I spent too much of my former life in consulting, where 2x2 matrices seem to grow wild on PowerPoint slides, but I have always found that a matrix is a useful way to help compare and contrast the tension between conflicting yet sometimes complementary ideas.

I mention this because I have recently fielded several questions about my options trading approach. In thinking about how I might want to discuss the subject, I realized that I have unknowingly been carrying around a 3x3 options matrix in my head for the past few years. Since I have yet to encounter anything like it, I thought this might be a good time to give the matrix a name and use it as a prop to discuss options strategies.

The graphic below, which I am calling the Options Opportunity Matrix, lays out a portion of my approach.

Let me take a minute to explain the graphic a little. When most investors consider whether or not to invest in a stock, they have an opinion about the future price of the stock. Their price forecast is represented by the Y-axis and is color coded for easy reference. The upper most row is green (3A-3C) to reflect an anticipated price appreciation; the lower row is red (1A-1C) to indicate a bearish price forecast; and the middle row is shaded gray (2A-2C) to reflect those instances in which investors expect a stock is not likely to move significantly up or down. The majority of investors live their lives in the top row, thinking only about those stocks that have a chance for significant price appreciation.

While options investors have a strong interest in price changes, they are also particularly concerned about changes in volatility. Here the columns and textures reflect opinions about future volatility, with column 1A-3A indicating an expectation of declining volatility, the more textured 1B-3B accounting for no change in volatility, and the highly textured 1C-3C reflecting an increase in volatility. Options traders are particularly interested in changes in volatility, both up (1C-3C) and down (1A-3A), so they are very comfortable initiating new positions when their opinions about a particular security fall into either of the outer columns.

In fact, an options investor that has an opinion about the direction of price and volatility should be happy trading in any of the nine scenarios on the matrix, and in so doing utilizing different strategies for each box. Multiple strategies are appropriate for each of the nine situations, but it is only important for the investor to be comfortable with one for each box. Frankly, some options investors may choose to focus on only one of the nine scenarios and can make a nice living with a narrow specialty.

In future posts on this subject, I will discuss the Options Opportunity Matrix strategy approaches in much greater detail, but in this first installment I want to make sure that the abbreviations are clear. To interpret the matrix, consider a forecast for an increase in price and an increase in volatility. Using the icons and/or the color and texture overlays, note that cell 3C recommends a long call position for this forecast. If an investor expects an increase in price, but a decrease in volatility, then cell 3A recommend selling a put. Finally, if an investor expects an increase in price, but no change in volatility, then the recommendation at 3B is to go long the underlying. Obviously, there are quite a few alternative trades, such as spreads, for each of these cells, but the basic trade is recommended here.

The matrix also identified what I call volatility trades. Long volatility trades, such as those in cell 2C are best executed when the forecast is for price to stay in a narrow range, while volatility increases. The ‘basic’ volatility trade is probably a short straddle, but my personal preference is usually for a long condor.

In the next part of this series, I will explain a little more of the logic behind the various matrix recommendations and talk about how I put the ideas behind this matrix into action.

[source: VIXandMore]

I mention very few possible trades on the blog and when I do so it is always for illustrative purposes only. As a consequence, I rarely feel an obligation to follow up on a previous post that identified a possible trade.

Today, however, seems like an opportunity that is too good to overlook because the timing and the math just happened to work out so nicely.

Exactly one week ago, in Is the SPX Going to Stick Close to 900?, I outlined my opinion that I thought there was a strong chance the SPX “would settle in a trading range of 820-980.” I also mentioned the “possibility that the SPX might start to feel some gravitational pull around the 900 mark and start trading in an even narrower range, with the 900 area becoming a No Man’s Land of sorts.”

For those who might have similar thoughts about the market and were looking to harvest some volatility as income, I suggested a menu of strategies that included straddles, strangles, condors, and butterflies.

I chose to illustrate one possible range bound trade with a short straddle using the S&P 500 index (SPX) as the underlying. With the SPX trading at just a shade over 900 at the time, the puts and calls could each be sold for 30.00 per contract. Fast forward one week and the SPX is still hovering around 900. After one week of time decay and a VIX that has fallen approximately 10% during that period, both the puts and calls have had their prices cut in half, from 30.00 to 15.00.


As expiration approaches, options trades move from the realm of investment to crap shot, but it is interesting to see a real life case study in time decay in which all the numbers behave as they normally do only in a textbook.

It is generally my intent at VIX and More not to recommend specific trades, but to highlight different ways to think about volatility. With that in mind, consider that during the past three days, the S&P 500 index (SPX) has straddled the 900 level in the closest thing to a sideways trading range since August.

Since the November 21^st low, I have been anticipating that the SPX would settle in a trading range of 820-980. So far the SPX has not traded north of 920, but I would not be surprised to see this happen.

What is even more interesting is the possibility that the SPX might start to feel some gravitational pull around the 900 mark and start trading in an even narrower range, with the 900 area becoming a No Man’s Land of sorts.

If the No Man’s Land scenario plays out even for just the next seven days, it is possible to lock in some nice gains with a straddle (or strangle, condor, butterfly, etc.) on the SPX, the SPY, or one of the leveraged variants.

As the graphic below from optionsXpress shows, the bet is essentially that the SPX will remain in a range of 60 points in either direction (a little less than 7%) in a little less than 7 trading days. The bottom line: seven percent in seven days. Volatility tends to decrease during the holidays, which would be a positive factor for those who choose to sell volatility.

If you are thinking about how one of the new 3x ETFs might play out in a similar trade, BGU is currently trading near 36 as I type this and a short straddle would be profitable in a range of about 28 to 42 – essentially a range of 20% in either direction.

[source: optionsXpress]