Stocks, the Euro and particularly the British Pound rallied on Monday with reductions in Implied Volatility in all three markets. While Crude Oil rallied, Gold fell only slightly. “Brexit” provided the perfect set-up for nervous market participants and seems to have had the same outcome as Y2K. Discomfort followed by a strong exhale.
The VIX (CBOE Volatility Index) shed a little more than 5%, although the percentage is not, in my opinion, an appreciable number. The VIX closed near its high of the day at 18.37 down 1.04 having traded significantly lower when the E-minis traded on their high. As the Stock Market Rallies and the S&P trades with higher at-the-money Strike Prices, the VIX is likely to calculate a lower Implied Volatility due to the fact that the higher Strike Prices have lower Implied Volatilities than farther out-of-the money Puts. The Implied Volatility Skew of the E-mini S&P Options, similar to the structure of the SPX, which the VIX is based on, explains why the VIX would typically get lower as the Stock Market Rises. The Table below shows the E-mini Implied Volatility Skew. The at-the-money strike is shown in red. Look at how the out- of-the money Puts on the right have an increasingly higher Implied Volatility the further you get out-of-the money. On the Call side, the left, the Implied Volatility gets cheaper the farther you get out of the money. This Skew provides the potential to create positions, which if held, may make establishing a position much easier to stomach.
In addition to the reduction of Volatility in the VIX, the British Pound also sawa significant decrease in Implied Volatility. The major problem with trading Options on the British Pound is the substantial lack of liquidity. The US$/British Pound Futures scarcely trades any options and the FXB (Currencyshares British Pound Currency Trust) lacks the liquidity for one to trade in a reasonable manner. For those that disregarded the essential nature of liquidity and sold Puts last week, the rewards were still excellent. However, in the long run, Trading Options in illiquid markets is an extremely difficult environment for one to make money.
“Brexit” provided all of the basic uncertainty necessary for a volatility spike and market over-reaction. In the Agricultural Commodities, specifically Sugar, Coffee and Soybeans, weather provides the opportunity for similar uncertainty. For those that like the manageable risk of long options, it is essential to compare the long-term Historical Volatility to the Implied Volatility of the Options that you are planning on trading. The rallies we’ve seen in Sugar and Soybeans still provide markets with significant uncertainty.
There are Options Trading Strategies with excellent value for Bulls and Bears in a variety of markets. It is important to evaluate the Liquidity of the Options you will be trading, the Implied and Historical Volatility, the Implied Volatility Skew and the appropriate Options Trading Strategy that provides the best value to meet these goals. If you are not clear on these points, try an Individual Options Webinar Training Session to Improve your Trading Technique. Whether you are trading Stock Options, Gold, Crude Oil, E-minis or Soybeans Options, the Implied Volatility Skew can help you design an Options Trading Position which may likely meet your risk/reward requirements.
There are a couple of examples shown below taken about 20 minutes prior to Monday’s 4PM ET Close. The first is a Short Position in the E-mini S&P. It is a limited risk position which involves Selling Call Spreads and Buying Put Spreads. Make note of that while the Call and Put Spreads are equidistant from the price of the Futures Contract, the Skew enables us to initiate a Short Position for excellent value. We are able to Sell the Call Spread and Buy the Put Spread for a 7.25 Credit. The second position is a Long Position, also in the E-mini S&P, which takes advantage of the Implied Volatility Skew to design a Long Position that you may be comfortable with. It is a Bull Fence with Unlimited Risk. Make note of how the Skew provides a significant pricing differential, however the risk involved in the Fence may be more than you’re willing to assume. The E-minis have a very large Skew, and in any Stock or Futures Contract with an appreciable Skew may be possible to provide some comfort in the positions you are taking. If you have any questions, Contact Us.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.