VIX Volatility is Back: Here’s How to Profit from a Complacent Market
by Karim Rahemtulla, Options Expert
Tuesday, January 5, 2010: Issue #1168
The stock market kicked off 2010 with a bang, as the major indexes used strong manufacturing data to scoot to 15-month highs.
As always, though, the movement of the CBOE Volatility Index (^VIX) dipped under the radar. Based on options activity on the S&P 500, this widely watched – but poorly reported – gauge of fear and complacency among investors quietly slumped by more than 6%, edging toward the 20-point mark.
This means little to many investors. But savvy onlookers know that now is the time to pay more attention…In my column on volatility and the VIX a couple of months ago, I warned that a drop under 20 implies that investors are becoming more complacent about the market – and that it might be time to tighten your stop-losses, or lighten your positions as a result.
Moreover, a move toward 10-15 points is a signal to sell your positions, as it indicates that investors are buying significantly more S&P call options than puts. Such an imbalance suggests a high level of complacency, with a market correction usually imminent.
We’re not quite there yet. But that doesn’t mean you still can’t make money at current levels. The question is: Do you know how?
What You Should Do When the VIX is Low
When the VIX is this low – and trending lower – you can capitalize by buying put options, especially longer-term ones. The reason is two-fold…
- Time: Long-term put options give you plenty of time for a market correction to occur, thus making you money. For example, if you buy a two-year put on the S&P 500, you’re betting that the index will fall at some point over the next two years – a pretty sure bet in my book.
- Low Volatility: What makes the trade even better is the fact that the VIX is low. That’s because when the VIX is low, it means stock volatility and options premiums are also low, which gives you cheaper entry points.
And when it comes to the price of options, it’s the underlying volatility of the stock in question that is a crucial factor. (Others include time to expiration, the share price and risk-free rate of return, but volatility is the key driver.) Given that the volatility number is low – as it is now – option prices are correspondingly low.
Of course, it’s also at this point that most people aren’t interested in buying put options, since they’re too busy salivating about profits from the long side. Hence the complacency factor. And it’s tough to profit from a short-term trade, as history has shown that investors can be very complacent for a surprisingly long time!
So it pays to take a long-term approach…
How Volatility Impacts Options Prices
As Alexander Green noted in yesterday’s column, one of the best investment strategies is to adopt a contrarian investment stance, and go against the grain.
And whether you’re interested in merely preserving your capital, or profiting from moves that are counter to the market’s trend, you have to add some protection to your portfolio – especially when the protection is so cheap.
Let’s consider a company like Bank of America (NYSE: BAC). I’ve included the options pricing tables below, so you can see how it works. Based on current volatility of 43, the price on the $10 two-year put option should be around $1 or just lower.
| Input Data | |||
| Stock Asset Price: | US$ | Example: “25.00″ | |
| Option Strike Price: | US$ | Example: “15.00″ | |
| Maturity (Time Until Expiration): | Years | Example: “3.5″ | |
| Risk-Free Interest Rate: | Annual % | Example: “.05″ (for 5%) | |
| Volatility: | Annual % | Example: “.20″ (for 20%) | |
| Options (Fair Value) | ||
| European Call: | US$ | |
| European Put: | US$ PRICE OF PUT | |
This is a far cry from the dark days of the financial crisis when BAC shares sported a sky-high volatility of 150. Take a look below to see what the price of the put would be in this case…
| Input Data | |||
| Stock Asset Price: | US$ | Example: “25.00″ | |
| Option Strike Price: | US$ | Example: “15.00″ | |
| Maturity (Time Until Expiration): | Years | Example: “3.5″ | |
| Risk-Free Interest Rate: | Annual % | Example: “.05″ (for 5%) | |
| Volatility: | Annual % | Example: “.20″ (for 20%) | |
| Options (Fair Value) | ||
| European Call: | US$ | |
| European Put: | PUT PRICE BASED ON HIGHER VOLATILITY | |
As you can see, the price for the puts today is obviously much lower than during the crisis-hit days. But it gives you an idea of just how much volatility can impact options prices, and demonstrates the advantage of trading based on volatility.
Good investing,
Karim Rahemtulla
Related Investment U Articles:
- The VIX Volatility Indicator: How to Gauge Future Market Behavior
- The VIX Indicator: Watch This Index to Gauge the Market’s Mood… And When to Profit
- What the VIX Is Indicating You Should Do Right Now
- How to Buy Gold for $100… And Get $200 Back
- How to Recover When Your Option Trades Turn Against You
8 Responses to “VIX Volatility is Back: Here’s How to Profit from a Complacent Market”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
‘ Let’s consider a company like Bank of America (NYSE: BAC). I’ve included the options pricing tables below, so you can see how it works. Based on current volatility of 43, the price on the $10 two-year put option should be around $1 or just lower.’
GENTS- WHATS A CURRENT VOLATILITY OF 43 MEAN?
ALSO DECIPHER THE COST OF A 2 YEAR $10 PUT OPTION AS $1 PLEASE? DO YOU MEAN ONE DOLLAR, 10 DOLLARS, 100 DOLLARS?
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Perhaps the unexpected high level of optionactivity during 2009 can be traced to the increased number of leveraged ETF’s. It is my understanding that they achieve 2x or 3x results by using options.
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Karim…
I really don’t think you mean to help with this article, you are simply trying to create some buzz for one of your investment letters. But let’s get past that and get at the article and the content…
I have been studying options but this article was a complete mumbo-jumbo to me.
I understood the text portion and the main point but the example was totally confusing – I have no idea what you were doing.
Because buying put protection during low volatility is a very topical idea, could you please explain in plain English and in a simple step by step example what your proposed strategy is.
I have no idea how to approach or execute your example in the way you laid it out. Frankly, it was a badly done article.
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Zoltan,
Basically, what Karim was saying is that during periods of low volatility buying put protection is much cheaper than times of high volatility. And, it is during these times that investors want to buy “cheap” protection to protect profits as the price of the puts can increase much faster than the decline in the market if volatility picks up.
Thank you,
Investment U
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WHERE DO YOU GO TO DETERMINE THE VOLATILITY ON BAC IS 43?
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Karim I fully agree with you & your strategy. My experience tells me same thing. Now is the time to be of more cautious.
Thank you
MGSANE
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karim,
What is the best way to play options on the VIX? What strike and month for hedging for the eventual market sell-off would you suggest? Finally, when the market does turn over, what specific Leap vechicles would you suggest to lock in a long term 10 bagger? Would precious metals play a part in hedging for long term gains?
Thanks!
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J.M.,
Those were some rather detailed questions, which probably would require a very lengthy response, so we’d just like to let you know that Karim wrote us to say that he will do his best to address those questions in a future article. So stay tuned!
Good investing,
Investment U
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