Fear is coming back into the market: Strategist

The CBOE S&P 500 Volatility Index, also called the VIX and know for being Wall Street's fear gauge, is back above 20. All Star Charts Chief Options Strategist Sean McLaughlin tells Yahoo Finance Live that after being range-bound, the fact that the VIX is above 20 "means something...there is definitely fear coming back into the market." So what does that mean for options traders? McLaughlin says it that, for him, he is "looking to be a net premium seller. I'm not looking to make any aggressive directional bets. I'm definitely looking to sell premium." Watch the video above to find out how McLaughlin is using ETFs to "express" his bets.

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Video Transcript

JULIE HYMAN: And now we're heading to the options pit volatility, a key mover as the VIX index hovers around its key level of 20. For a look at how to invest around this theme, joining us now, Sean McLaughlin, All Star Charts Chief Options Strategist. And this segment's sponsored by Tastytrade.

So Sean, we have seen, finally, volatility start to tick up a little bit. And despite the sort of selling pressure that we have been seeing within stocks, we haven't seen the VIX sort of get to 20 until now. What do you think that reflects?

SEAN MCLAUGHLIN: Well, I'm old enough to remember when VIX above 20 was a big deal. And up until this year, we had a couple of years where VIX was persistent above 20. And people thought that was the new normal. And perhaps that was the new normal for a while.

But now that the VIX has kind of gotten back into its traditional range of 12 on the low end and 20 on the high end, now that we're back at 20, it means something. And we're seeing it in the indexes, the S&P is off, I don't know, what is it? 8% off its highs. IWM, the Russell 2000, those stocks, small cap stocks, are looking even scarier right now.

There is definitely fear coming back into the market. And as an options trader, when fear is coming into the market and implied volatility is rising, I'm generally looking to be a net-premium seller. I'm not looking to make any aggressive directional bets. I'm definitely looking to sell premium.

And in this environment now where we have big cap earnings on deck, a lot of the big names that everybody watches, I, as an options trader, don't like positioning ahead of big earnings announcements. I know that there's a big cottage industry of options traders that love to trade earnings events. I'm not one of them. I like to sleep at night. I like to step aside when the big companies are announcing earnings.

But I do participate through sector ETFs. And an environment where we are right now, where implied volatility across the board is pretty elevated, but we have that binary risk of gap risk, overnight gap risk with earning events, I am sticking to ETFs to express my bets. I'm looking at ETFs right now that have higher implied volatilities yet are also in a bit of a range. So names at the top of-- my top of mind right now are the USO, the oil index, and XLP, which is consumer staples. Even the technology sector ETF is showing signs of being in a range. So that's how I'm playing this environment right now. Call me conservative, but again I like to sleep at night.

JOSH LIPTON: And Sean, let's just talk a little bit more about some of those ETFs, like, for example, the XLK, Sean, the big tech ETF, with big tech on deck here on earnings. What is an option strategy there you think that traders could consider?

SEAN MCLAUGHLIN: So with the XLK, one of the go-to strategies I go to in situations like this is I like to sell strangles. So a strangle is a trade, a spread trade, where you sell an out-of-the-money call, and you sell an out-of-the-money put. You collect a credit for that trade. And that credit is the most you could earn in the perfect scenario if you held that position to expiration and the underlying instrument closes between those two strikes.

Now, I generally do not do that. I'm not going to hold that position all the way to expiration. I will generally take profits when I can buy it back for about 50% of what I sold it for. So I'm just making numbers up here, because I don't have them in front of me. But if I sold that out of the money spread or a strangle on XLK and I got, let's say, $2 for it today, I'll look to close it back, buy it back for $1, maybe a little less. I'm not being greedy. I'm not-- this is not a trade you're trying to hit a home run on. You're going for a high probability bet. And look, high probability bets, they don't pay a lot, because you're not-- you have the odds on your side that it's going to be profitable.

That's the way I trade these. And for risk management purposes, I keep it really simple. If either of my short strikes go in the money, so if the XLK were to trade above my short call or trade below my short put, I'm not going to argue with the market. I'm not going to hope and pray that it comes back. I'm just going to close the spread down and move on to the next trade and book the loss.

JULIE HYMAN: And Sean, I have-- admittedly, I have not talked options in a while. So to take a step back for a minute, I feel like options is one of the areas during the pandemic when people were home. They were looking at crypto. They were learning how to trade options. They were trading single stocks. Now a couple of years on, what are we seeing in terms of volume of activity in the options market?

SEAN MCLAUGHLIN: Well, we are seeing options volumes continue to rise across the board, especially with the introduction of zero DTE options heavily focused on index trading. So like the S&P 500 options and the NASDAQ options and Russell 2000 options, they have the zero DTEs. You're seeing a lot of trading action there.

And in the early days, when we saw the surge of zero DTE options. It was mostly driven by retail traders. And I'm not saying that's good or bad. It's just that's what the data was showing us. But what we're seeing now in reports that I've been reading in various places, that volume has been kind of taken over by institutional players.

Institutional players like the zero DTE options because they can hedge event-specific risk a little bit more fine-tunely, right? I mean, especially with earnings coming up, if they have heavy tech exposure, for example, maybe they've got a lot of big position in Google or Apple or something like that, they want to hedge themselves overnight for one or two days. And they want to do it as cheaply and as affordably as possible.

So they're finding that these zero DTE options are giving them a lot of flexibility and opening up a lot of new avenues for risk management that might not have existed before. But no matter how you slice it, whether you're retail or institutional, volumes are skyrocketing. And that's a trend that's going to continue.

JOSH LIPTON: Sean McLaughlin, thank you so much for joining us today, Sean. Appreciate it.

SEAN MCLAUGHLIN: Thanks for having me, guys.