When markets are experiencing low volatility , it is tempting to just go out and buy options. That strategy can work, but when options are still relatively expensive, there may be better alternatives for intermediate-to-advanced traders.
When the VIX is low it suggests that option premiums are cheap. When the volatility index dipped below 18 recently, some suggested put buying as a good way to hedge equities. That may be true, but the thinking is a bit simplistic to apply to all instances.
The VIX was indeed around the lowest levels in six months recently, down more than 60 percent from its August highs. This suggests that S&P 500 options are relatively cheap. But when you compared the expected volatility of the option prices with the actual volatility of the market, you get a different picture.
The 30-day historical volatility was below 10 percent, just off its 52-week low from May. This means that the VIX was at an 80 percent premium to actual volatility.
That is a huge difference and one that is rarely seen. It suggested that traders were expecting a big increase in volatility, but no one knows when it will come. Low volatility can stay for a while, making puts an expensive way to get insurance.
This doesn't mean that you should avoid insurance altogether, of course. But one way to mitigate some of the cost is through more advanced spreads.
A backspread , for example, involves selling near-term options and buying more later-dated out-of-the-money options of the same type.
For instance, one might sell a SPY March 133 put and buy two of the 128 puts for a credit. The credit is kept if shares are above $133, but the trade can really profit if shares fall sharply and implied volatility increases.
The trade can also be done by bullish investors looking for to replace stock with options . We saw one such pread in Sears on Feb. 8.
A trader sold 2,125 June 50 calls for $5.10 and bought 6,450 75 calls for $1.60. He or she can keep a small credit if SHLD is anywhere below $50 but can also make a huge profit if it runs higher.
The risk in a backspread is if the stock grinds higher and time decay eats away at the position. So with SHLD, the worst-case scenario is if the stock is up around $75 at expiration. This is why most traders use backspreads out a few months and don't hold onto the position until expiration. (See our Education section)
Backspreads are complex trades, and because of their multiple moving parts they may not perform as you would expect. But they can be excellent trades, especially in environments like the current one.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Feb. 18. Chart courtesy of iVolatility.com .)
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