As I sit down to write this, we are on day 4 of a government shutdown. With little sign of an agreement forthcoming, you might think that the equity
markets would be in selloff mode. A quick review of the charts shows a slight increase in daily high/low price swings but no significant pullback – yet.
The $DJIA attempted to break support yesterday morning with a lower open and pullback of almost 200 points. This didn’t last long as a bounce took the
average off its low and holding support. The SPX has a similar chart with longer term support holding. The one quantifiable change this week in the markets
is an increase in the VIX, the measure the market uses to gauge future predicted price volatility. When the VIX rises, it is loosely interpreted that fear
is beginning to creep into the marketplace. The VIX has been relatively low most of 2013 as the markets have continued to rise with a few “blips” toward
the 18-20 level on the back of short-lived equity pullbacks.
As a credit trader, I like to sell premium to others with the expectation that the options I sell will expire worthless. When levels of the VIX are
relatively low, this means the market is not anticipating much movement. This translates to lower levels of implied volatility priced into options’
premiums making the overall premiums lower. It we think of implied volatility as a balloon, during these periods of low IV the balloon is deflated. This
makes it challenging to find opportunities to sell premium for good returns relative to risk taken in the trades. This week, the VIX has started to rise
with concerns about the length and ultimate effect on the markets of the government shutdown. This has caused the balloon of IV to begin to inflate again.
It is a slight inflation at this point with the VIX currently sitting at 17. Should this shutdown continue for a lengthy period of time, however, you may
see a continued inflation of IV providing interesting opportunities for those of us who like to sell premium.
One of my favorite spread trades is the bull put which combines a short put at a higher strike price than the long put in the same expiration series. I
prefer to do these spreads several months out in time giving me the ability to sell premium at strikes that are significantly out-of-the-money. This
enables me to have time on my side to make adjustments to the trade should they be necessary, many times well before my short strike has been violated by
downside movement in the underlying equity. I look at these trades as being “outside of the noise” of the daily fluctuations in the markets. The ideal time
to write these spreads is when the balloon of IV is inflated and likely to go lower – after pullbacks in the market. We haven’t had too many of these
opportunities so far this year, but I did use the very short-term pullback in June, as well as the more recent one in August, as opportune moments to
use this trade. I layered into bull puts each and every day of these pullbacks at better and better credit levels with the expectation that the overall
bullish trend would ultimately ensue. As the markets did find support and head higher, I had the benefit of IV going lower as well as bullish equity
momentum working on my side with these credit spreads. They worked amazingly well! I have started in very small amounts to do these same trades again on
the back of the political gridlock causing IV to rise slightly again. I am now cautious as the markets may be in for a further decline, but should
that occur, IV will likely continue to go higher providing better and better credits on these trades which I will use to my advantage.
We have all heard the old adage, “There is a time to reap and a time to sow”. I use my understanding of IV and its relationship to option premiums to
give me the opportune moments to both reap and sow these credit trades. I guess we could call this a potential “silver lining” to an inept political
system!
Karen Smith
OptionsANIMAL Instructor
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