Option Volatility Trading with the VIX 

The adage buy low and sell high was originally used in reference to price, but can also be applied to the practice of trading volatility.  In fact, even as an option trader looking to trade market price as opposed to volatility, ignoring measures of potential explosiveness while entering or exiting a market could mean financial peril.   While many traders, whether beginner or pro, understand the concept of buying options during times of low volatility and selling them during times of high volatility, emotions often lead a well planned strategy astray.

Unlike traders that are looking to profit from a directional move in price, volatility traders are more interested in the pace at which the market is moving than the direction.    However,  I argue that it is important to chart both price and volatility.  Doing so provides trades with a better understanding of the 'big picture'. 

In my opinion, the most efficient means of trading equity market volatility isn't through the VIX index, or any other similar measure.  Liquidity is a major factor working against the viability of doing so.  Instead, I believe that traders should look to buy or sell options on S&P 500 futures.  The S&P is a broad based index and its value is sharply impacted by market sentiment and the corresponding volatility.  Thus, a trader that is of the opinion that volatility will increase may look to buy volatility through the purchase of options written on S&P 500 futures and those looking for volatility to decrease may look to sell volatility buy going short options on the index.  Insiders often refer to the practice of buying or selling options as "going long volatility" or "going short volatility". 

Trading Volatility through Premium Collection

As mentioned, one way to speculate on variations in volatility is through the practice of option selling, often referred to as premium collection.  It is important to realize that I am referring to trading American style options which allow traders to buy, sell or exercise options at any time prior to expiration.  This differs from the European style versions that offer far less flexibility.  The increased level of flexibility tends to have a positive impact on the value of the option and thus the amount of premium collected for selling it.  In other words, option buyers may get more value using European style options (referred to as end-of-month options in the S&P) due to lower premiums; conversely this concept works in favor of option sellers of American style options.   

Why Option Selling?

Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the premium collected should outweigh any potential payouts.  This theory is based on the assumption that more options than not expire worthless which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange.  Unfortunately, just as insurance companies are sometimes forced to honor their policies on excessive claims, option sellers are vulnerable to monster market moves than can be potentially account threatening.  Preventing such disasters ultimately come down to timing of entry along with a good understanding of volatility, market sentiment and market knowledge.  Additionally, experience, instinct and, of course, luck will also come into play.  Yet, in my judgment option selling is a superior strategy in the long run.

Options selling advocates and equity market volatility traders seem to migrate to the S&P 500 futures market.  Both the full sized and mini versions of the contract provide ample liquidity to actively trade the market without the burden of unreasonable bid/ask spreads. 

CBOE's Volatility Index (VIX)

An important measure of volatility when referring to the S&P is the now infamous Chicago Board Options Exchange's Volatility Index, often simply referred to as the VIX.  According to the CBOE, the VIX is a "key measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices" and has become one of the most prominent measures of market sentiment in the world.   Before 2007 the VIX spent a majority of its time below 20, it is now obvious that times have changed....at least for now. 

Keep in mind that there were adjustments made to the parameters of the index in 2003 that may have arguably affected the value of the index. For our purposes we will disregard the possible discrepencies.

It is important to note that increased values of VIX are highly correlated with higher option premium in the form of higher implied volatilities and are ideal conditions for an experienced option seller assuming that she is willing to accept the risk of participating in such a market. 

The Quest for Implied Volatility

Unlike the VIX which is derived from the underlying futures price among other factors, implied volatility is a component of option price.  The implied volatility of an option, is the amount of volatility implied by the market value, or price, of the option.  In other words, the implied volatility is forward looking in that it incorporates the current market precariousness as well as what market participants are expecting at some point in the future. 

You may also find that market emotion and sentiment are a component of implied volatility.  As long option traders scramble to go long volatility through the purchase of options in an attempt to profit from the latest hype, option premiums can and do explode exponentially.  As a sidelined option seller, these types of conditions should be inviting.  The premise of this approach is to attempt to sell options to buyers that are simply "late to the party".  The key is making sure that as a seller you aren't too early.

Selling Puts can be Lucrative, but it Comes with a Hefty Price Tag

It is often the case that selling puts is more lucrative than calls, but the added reward carries baggage in the form of additional risk.  Due to the increased levels of risk, timing becomes crucial.  By nature an option selling program tends to leave room for error in the execution.  Nonetheless, being short puts in a spiraling market can quickly change that. 

The phenomenon of put premium in the stock indices being larger than call premium is often referred to as the volatility smile.  The volatility smile is a long observed pattern in which at-the-money options have lower implied volatility than out-of-the-money options along with the argument that there is more value in owning a put relative to an equally distant call.  This scenario seemed to be born after the crash of 1987 in the U.S. 

While there are no crystal balls to let us know when a market will turn around and how low that it may go before it does, being aware of historical patterns in price, volatility and market sentiment may help to avoid a compromising situation.  Let's take a look at the relationship between the VIX and the S&P.

VIX and the S&P 500

Looking at the chart below, it is obvious that the S&P 500 has been able to forge recoveries during times of spiked volatility as measured by the VIX.  Armed with this knowledge, it may be a viable strategy to look at erratic , and many times irrational, trade as a point of entry for put sellers. 

For example, based on this assumption put sellers may have fared well during the lows in 1998, 2001, 2003 and 2007.  That is of course assuming that the trader wasn't early in his entry.  If a short volatility trader enters a market prematurely, there is a strong possibility that the trader will be forced out of the market prematurely due to lack of financing or margin.  Let's take a look at an example of a trader that is interested in selling volatility by going short S&P puts.   

Beginning in the middle of 2002 and throughout the beginning of 2003, put sellers with savvy timing may have done very well.  However, trading is a game of risk and those selling puts during those times were accepting great amounts of risk in order to reap the reward. 

Let's take a look at a continuous S&P 500 futures chart during the 2002/2003 lows.  While the VIX is a great indication of volatility and extreme market sentiment, it is also helpful to look at indicators of volatility such as standard deviations.  Luckily, the creation of Bollinger Bands allows us to visually determine market volatility through the line plot of two standard deviations from its mean.  Times of high volatility  are denoted by wider bands, or a larger standard deviation, and times of decreasing volatility result in narrowing bands. 

As market volatility increases, so will option prices.  During such times, option buyers are forced to pay extremely high prices for options that in theory are more likely to expire worthless than not.  On the other hand, option sellers are provided top dollar for accepting theoretically unlimited risk. 

Higher premiums collected not only increase a traders profit potential but it also increases the room for error.  The money collected for a short option can be viewed as "cushion" in that it defines the amount in which the trader can be wrong and still make money by shifting the reverse break even further from the market.  The RBE of a short put is calculated as follows:

RBE = Put Strike Price - Premium Collected + Commissions and Fees

As you can see, the more money that the option seller collects, the deeper-in-the-money the option can be at expiration without resulting in a loss to the trader. 

According to the hypothetical data available to us, in July of 2002 with the September futures price near 780,  it may have been possible to sell the August S&P 500 futures 680 put for $4.3 in premium which is equivalent to $1,075 before commissions and fees.  If this was the case, a trader could have collected a little over a thousand U.S. dollars for an option that was, at the time, approximately 100 points or nearly 13% out-of-the-money. 

At expiration, this trade would yield the maximum profit of $1,075 before commissions and fees if the futures price is above 680.  Ignoring transaction costs the reverse break even on the trade is at 675.7.  This simply means that this particular trade makes money with the futures price trade anywhere above 675.7 before commissions and fees.  Please note that the amount of commission paid will reduce the premium collected and shift the RBE closer to the market.  To look at it in another perspective, the trader can be wrong by 104.3 points after entering the trade still manage to break even.  If the trader's goal is to put the odds in their favor, this seems to  be the solution. 

Conclusion

Without regard to transaction costs, trading is a zero sum game;  for every winner there will be a loser. Thus, putting your odds ahead of those of your competition is a must.  In my opinion, selling options during times of high volatility while exercising patience and incorporating experience is doing just that. 

With that said, where there is reward there is risk; in efficient markets you cannot have one without the other.  This strategy should only be attempted by those that have ample risk capital to allow for potential draw downs as well as the ability to manage fear and greed.  Fearful traders are vulnerable to panic liquidation at inopportune times in terms of market volatility and option pricing.  Likewise, greedy traders are tempted to sell options closer-to-the-money in hopes of higher payouts but the risk may turn out to be unmanageable.  I strongly believe that less is actually more when it comes to premium collection.  Trade less, collect less and hopefully enjoy more success.

* There is substantial risk in trading options and futures

Carley Garner, senior analyst and broker at DeCarley Trading, is the author of "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall.  Her trading e-newsletters, The Stock Index Report and the Bond Bulletin, have garnered a loyal following; DeCarley Trading is proactive in providing free trading education.