We are likely to see long periods of trading within an ever-narrowing channel this year, punctuated by short bursts of volatility in which markets move sharply before settling into a new trading range.
Although this is typical market manoeuvering, the volatility we see should be more pronounced because of government action, which will act as the catalyst for the sentiment shifts that drive volatility. So, for clients who are not market-timers, covered-call writing is a good long-term strategy that delivers excellent returns in range-bound markets.
In particular, we should look at straddles as the options strategy that takes advantage of volatility extremes. A straddle involves the simultaneous purchase of a call and a put on the same underlying security, both having the same strike price and expiration date.
At the time of writing, volatility appeared to be at an extreme low; that led me to look at a long straddle on the S&P 500 depositary receipts (symbol: SPY).
A straddle makes money if the underlying security moves beyond the trading range as determined by the net premium paid for the call and the put. For example, when SPY was trading at US$148.33 in mid-January, the SPY March 149 call (expiring on March 27) was trading at US$2.70 and the SPY March 149 put was trading at US$3.90. The combined premium to buy both the call and the put is a net of US$6.60.
The SPY March 149 straddle will profit if SPY closes above US$155.60 (US$149 strike price + US$6.60 premium = US$155.60) or below US$142.40 (US$149 – US$6.60 premium = US$142.40) before the options expire. The price point at which the long straddle is profitable corresponds with the implied trading range for SPY.
Given that a long straddle incorporates two short-term options that will decline in value as a result of time decay, it is important to have a clear opinion regarding whether the options are overstating or understating future volatility. You buy straddles if you believe that volatility has lessened, and sell straddles when volatility is extremely high. Look for entry and exit points based on extreme readings benchmarked against historical norms.
To ascertain extreme readings, look to the Chicago Board Options Exchange’s volatility index (symbol: VIX), which measures the volatility being implied by “near to the money” S&P 500 composite index options. At the time of writing, VIX was trading at US$12.46. That’s a 52-week low – but is it an extreme reading?
Determining extremes necessitates boundaries that require a normal value as the midpoint. So, what is a normal volatility level?
There are many interpretations about what is “normal.” I use VIX’s 50-day moving average to represent normal volatility because this measure reflects different market environments and removes much of the day-to-day noise.
If the daily VIX is above the 50-day “norm,” the implication is that options are relatively expensive. When VIX trades below the norm, options are cheap. But knowing that options are cheap or expensive does not tell us whether volatility has reached a level that typically precedes a major change in direction. To determine extremes, we have to integrate another technical tool: Bollinger bands.
Developed by John Bollinger, a financial analyst in the U.S., Bollinger bands graphically display a trading range around a moving average by using two points determined by using standard-deviation calculations. In this example, the 50-day Bollinger bands graphically display an expected trading range around the VIX’s moving average.
Extreme readings would occur if VIX were to touch the upper or lower Bollinger band. At the time of writing, VIX was trading on the lower Bollinger band, which suggests VIX is at an extreme (low) level; this supports an expectation of a breakout in volatility that would lead to higher values for SPY calls and puts.
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