Wednesday’s Volatility Spike Was a Gift for S&P 500 Option Sellers

After a long absence, volatility returned — epically on Wednesday. The S&P 500 slid 2.4%, marking its largest down day since last October.

Person on the phone points at charts on a computer screen.

Source: Shutterstock

As dramatic as that was, the real excitement transpired in the options market. Demand for derivatives soared, driving the CBOE Volatility Index to 37.21 for a single-session gain of 61.64%.

Today, we’re digging into the implications of the fear spike and identifying exactly how you can use the panic to your advantage. Let’s begin with a fresh look at the S&P 500 chart to see just how much damage, if any, was done by this week’s slide.

S&P 500 Stock Chart

S&P 500 chart with bounce off 50-day moving average

Source: The thinkorswim® platform from TD Ameritrade

Though we can track the index with various vehicles, I’m going to use the futures chart because it’s the cleanest and isn’t cluttered by the daily gaps that plague the S&P 500 ETF Trust (NYSEARCA:SPY). When analyzing a pullback like the one we just witnessed, keep in mind declines come in one of two varieties.

The first is a common retracement that carries prices toward support. They shake out weak hands and create lower-risk entry points. What they don’t do is break support and/or long-term trendlines. In other words, they don’t reverse the trend.

Trend enders are the other type of selloff and are a more vicious variety. They linger and take more effort to recover from. Because they break support, it’s more challenging for future rallies to go the distance.

Fortunately for stock lovers and equity bulls, this week’s market swoon has thus far been a common retracement. While the S&P 500 futures chart did breach the 20-day moving average, marking a slightly more significant amount of weakness than the other post-October dips, it has thus far held the rising 50-day moving average. That, more than anything, is the victory worth celebrating.

Since I’m always open to all potential scenarios, I’ll hasten to add that if we break Wednesday’s lows ($3706.50), it will mean the initial bounce attempt failed, and we’re dealing with a true trend ender. This would also mean we’re breaching the 50-day moving average. Historically, when prices fall below the 50-day, higher volatility and a downtrend are almost always in the offing.

The VIX Super Spike

CBOE Volatility Index (VIX) with super spike

Source: The thinkorswim® platform from TD Ameritrade

As far as VIX spikes go, Wednesday’s was a doozy. What was so fascinating is that it only took a 2.4% decline in the market to spark such a historic rip. Usually, you’d see the S&P 500 down 4% or more to warrant such a rapid rise in volatility expectations. I’ve seen interesting bullish and bearish arguments in the aftermath of the surge, but I prefer to focus on the one indisputable takeaway. Options premiums have expanded. So too has the payday for options sellers.

From naked puts and covered calls to credit spreads and condors, a whole host of strategies just became more appealing. If you think the VIX spike could spell the beginning of a more volatile — and more choppy — market, then iron condors are worth a shot.

SPX Iron Condors

Let’s approach this using options in the cash index for the S&P 500, the SPX. The structure of an iron condor involves selling an out-of-the-money bull put and bear call spread. Because of the higher volatility, we’re able to build a wider range of profit than normal. If the S&P 500 remains between the short strikes of both spreads, you’ll pocket the original credit received.

The Trade: Sell the Feb $3480/$3490 bull put and $3980/$3990 bear call for $2 credit.

In this case, we’re betting SPX will sit between $3480 and $3980 at February expiration. The trade cost (and risk) is $8.

On the date of publication, Tyler Craig held a NEUTRAL options position in SPX.

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