Wednesday, August 25, 2010

Fading Away

The recent sell off in the equities market has ushered in yet another uptick in fear. During the past few weeks, the CBOE Volatility Index (VIX) has surged over 30%. While the increase in pessimism and insurance premiums may have investors cursing the market, you can bet volatility traders are looking at this as a visit from good ole' Mr. Opportunity once again coming to knock on their door. These traders are likely taking a contrarian viewpoint by seeking opportunities to fade the volatility extremes that have recently cropped up.

So, how might those who have been bit by the contriarian bug go about gaming some mean reversion in volatility? Well, take your pick. Nowadays we've got a smorgasbord of volatility products to play with. You could dabble with bearish plays on the VIX or VXX; or perhaps try out the newer inverse volatility product- the XXV. Of course, since the VIX is simply a reflection of implied volatility on S&P 500 options, you could try your hand using options on the SPX or SPY which afford bearish volatility exposure such as short put spreads or put ratio spreads.

Traders electing to take the S&P option route also need to consider their outlook on the underlying Index as it is possible to enter short volatility plays that provide either bullish, bearish, or neutral exposure. One of the strategies I've mentioned in the past which profits from a decline in implied volatility as well as neutral to mildly bearish movement in the underlying is the put ratio spread.

Suppose you purchase the Sept. 100 put for $1.15 while simultaneously selling three Sept. 97 puts for $.70 apiece. The net credit comes out to $.95. Consider the risk graph below modeling the effect a drop in implied volatility has on the PnL of the position (click image to enlarge).


Anonymous said...

so good to see a blog that focuses on exiting trades rather than simply constantly offering new trade ideas. Exiting trades is fully half the trade the trading process that the blog community spends an eighth the time discussing.. thanks.

Tyler Craig said...

Appreciate the comments. I posted an update to this 1x3 spread today:

King Kong said...

I would like to comment about trading verse investing. Why can their not be something in between the two.