Low Volatility Is Depressing Options Sellers

Barring the occasional spike to the high teens, the CBOE Volatility Index (CBOE:VIX) appears to have found a new home in the 12-14 zone this year.

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While the low-volatility regime settling over Wall Street might be applauded by bull market lovers, though, it does have its detractors.

Among the disaffected are option sellers who rely on elevated implied volatility (IV) to generate profits. The cheapening of option premiums amid a low-volatility regime often causes profit opportunities to dry up for these participants.

Another way to view just how low IV is these days is to compare it to recent measures of historical volatility (HV). Whereas implied volatility is derived from option premiums and reflects how volatile the market is expected to be in the future, historical volatility is derived from the underlying asset’s price and reflects how volatile it has been in the past. Because of the volatility risk premium, implied volatility usually runs about 3 points higher than historical volatility on average.

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And yet, with the depressed VIX, we’ve actually seen implied volatility trading below historical volatility for a couple weeks now.

Check out the accompanying chart which shows implied volatility (red line) overlaid with 20-day historical volatility (blue line). In the bottom panel is a yellow area chart measuring the net difference between both volatility measurements. When the chart is above zero, implied volatility is higher than historical. When the chart is below zero, historical volatility is higher than implied. The fact that the chart has been sub-zero for the past month effectively means that the market has been more volatile than the options were pricing in. That’s great if you purchased options … but not so great if you sold them.

Of course, there are many different types of strategies involving selling options. The spread strategy perhaps most adversely impacted by the current ebb in the VIX is the short call vertical spread, AKA the bear call spread. The risk-reward profile of the bear call spread is already skewed — because of its high probability of profit, the potential reward is far smaller than the potential risk.

Its asymmetric risk profile becomes even worse in a low-volatility environment. In addition, the out-of-the-money call options commonly used to structure a bear call spread are also relatively cheap due to a phenomenon known as volatility skew.

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As shown in the following option chain, out-of-the-money call options on the SPDR S&P 500 ETF (NYSE:SPY) currently trade with an implied volatility around 10% while the equidistant OTM put options trade with an implied volatility around 15%. The difference in IV is due to the predisposition of most market participants to buy downside puts for protection while selling upside calls via strategies like covered calls and collars.

The bottom line: Selling OTM bear call spreads is a bad way to go if you’re looking to hedge your portfolio. Instead, consider snatching up OTM puts or put spreads which offer a superior risk-reward tradeoff.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2013/05/low-volatility-is-depressing-options-sellers/.

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