With the Fed raising rates this afternoon, we could be in for a period of dramatic market swings. Here’s how you can profit in either direction using options. This is a win-win trade that can be placed by anyone no matter their level of experience or account size.
There’s been so much talk of low volatility these days, it’s easy to forget that most investors weren’t even aware of the existence of the VIX (the “fear gauge”) until the past few years. In fact, outside of futures and options, the VIX wasn’t tradeable for most investors until after the financial crisis hit. It was after the meltdown that VIX-related ETFs became so popular.
Speaking of the past, this past weekend I returned to Chicago for the first time in over seven years. It’s been nearly 20 years since I got my start as a market maker in options on the floor of the CBOE (Chicago Board Options Exchange). It proved to be a defining moment in my life, as I’ve since devoted my career to trading, writing about, and teaching options.
Although most options trading is now done online, it was fun seeing the exchange again after so many years. Back when I was on the floor, traders watched the VIX closely – but there was no way to trade it. (The first VIX products were futures and options made available in 2004.) Now volatility is basically its own asset class, and the trading of volatility products has exploded.
Needless to say, I’ve closely followed the rise of volatility trading, and this recent period of ultra-low volatility has my interest piqued. Many industry experts have expressed concern over “investor complacency” and are also concerned the trend of shorting volatility is going to end badly for the unprepared.
While there is some validity to these concerns, let’s look at a few other reasons for the low volatility we’ve been experiencing this year:
- Lack of economic surprises – Despite plenty of politically-related headlines, what really moves the market is economic data, especially unexpected data. There have been very few surprises in 2017 economically speaking.
- ETFs/funds and consumers with access to leverage can buy the dips – Leverage is cheap with interest rates so low and ETF popularity has exploded. As such, there’s a ton of money out there waiting to buy dips, which helps stabilize the market.
- Fixed income stabilized by Fed – We know central banks have or had been buying fixed income securities across the globe. With the fixed income market stable, there’s been no volatility spillover into equities.
- Reactions to political news are muted – Investors have discovered that sharp market reactions to political news are short-term, so have learned to avoid becoming overly aggressive during these periods.
With these reasons and others contributing to low volatility, it’s reasonable to say current levels of volatility are mostly legit. But with options so cheap (due to low volatility), how do you make money trading?
One of the issues with the growth of options trading is investors are generally told they can only sell options to make money. And while selling options is certainly the highest probability method for making money, it’s not the only way. When markets dictate that it’s time to buy options, you can’t ignore it.
So, with options as cheap as they are, here’s one excellent value trade you can make…
One of the most popular ETFs out there is iShares Russell 2000 ETF (NYSE: IWM). IWM, a common proxy for small cap stocks, tends to be more volatile than large cap ETFs. However, the market is currently pricing IWM options cheaper than the ETF’s realized volatility over the last 20 days. In other words, the options are too cheap based on what the ETF price has done recently.
You can see from the chart just how volatile IWM has been the last six months. So, with options so cheap, they you can make a great value purchase here. Plus, with options we don’t have to pick a direction with our trade. We can buy both a call and a put so we’re just looking for a move either way.
For instance, the IWM July 14th 141-143 strangle is trading for around $3.50. A strangle is just a term for buying the call and put at the same time in the same expiration but at different strikes. In this case, you’d be buying the 141 put and the 143 call for a total premium cost of $3.50, or $350 per strangle.
This trade gives you a full month of control, where breakeven points would be $137.50 or $146.50 in IWM. Either point could be very realistic in the next month. Plus, upside is unlimited should the ETF make a large move in either direction.
Remember, selling options isn’t always the answer. Sometimes when the market gives, you have to take – even if isn’t what you’re used to doing. If there’s anything I’ve learned in 20 years of options trading, that last sentence is definitely at the top of the list.