The ongoing market correction has been far from a clean, orderly pullback. Like a drunken sailor, it has wobbled to and fro, frustrating many short-term market timers.
The dizzying switchbacks from up days to down days have ushered in a new regime of elevated volatility. While it’s impossible to predict the duration and magnitude of the current downturn, it is fair to say a 5%-plus correction has been long overdue.
While those that thrive in docile, slow-grinding markets might be cursing volatility’s return, option-sellers who were tiring of the market’s one-sided trajectory are rather enjoying the recent change. Let’s take a look at a few key volatility measures to see just how much impact the recent uptick in market movement has had.
Click to Enlarge Interestingly, the pullback in the S&P 500 Index has had little effect on 20-day historical volatility. Sure it has lifted, but only to 10% from its recent low of 8%. So while the downturn might appear volatile on the surface, the percentage moves haven’t been large enough to really lift realized volatility much.
We have seen some rumblings emanating from implied volatility, however.
From its mid-May trough of 12.26, the CBOE Volatility Index (VIX) has climbed as high as 17.58, reflecting a notable increase in demand for options. Remember, the VIX is a mean-reverting statistic with an easily observable tendency of returning to some average level after deviating too far in one direction or the other. In assessing just how stretched the VIX is, we could use the popular Bollinger Bands indicator.
Click to Enlarge As shown in the accompanying chart, the recent surge has lifted the VIX above the upper band, revealing that it is indeed overstretched. Also of note is the fact that the VIX has risen to a similar level as the last two spikes in February and April.
Time will tell whether we follow in the footsteps of recent history by experiencing a sharp reversal back to the middle of the bands. Keep in mind the market pullbacks in February and April that acted as the catalysts for the twin VIX spikes were quite benign — 2.9% and 3.8%, respectively. So if the current downturn extends to 5% or more, the ongoing VIX spike could certainly exceed the prior ones.
On a positive note, the lift in implied volatility is increasing the appeal of option-selling strategies like individual credit spreads and iron condors.
Those who believe the market is in for a choppy, range-bound summer might use the recent lift in option premiums as an opportunity to sell iron condors in the SPDR S&P 500 ETF (SPY). For example, you could sell a July 147-152-169-174 condor — selling the SPY’s 152 put and 169 call and buying the 147 put and 174 call — for $1.05 credit.
If you have more of a bullish bias and view the current market dip as a buying opportunity, then consider selling bulling put spreads. The elevated volatility allows you to go further out-of-the-money to establish your position than you would have been able to prior to the market correction. One SPY trade you could make: Sell a July 155-150 bull put spread for a 74-cent credit.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
