Hard to imagine I’m talking about volatility again, but so be it. Last week I had sold some existing bearish hedges and by Friday was faced with establishing new positions before the weekend. Although that day’s rally certainly helped, implied volatilities [IV] were still pretty ugly for option buyers. What’s a trader to do?
A 1999 study indicates the S&P 500 Index (SPX) volatility exhibits fast mean reversion (see reference at the end of this article), so it was reasonable to think an IV crush lay ahead. At the same time, traders who waited to hedge in September because the VIX (a.k.a. volatility index) was approaching all time highs probably regretted the decision as the market continued to decline and the volatility index continued to move upward.
Nobody knows what the next day brings. Traders need to identify existing conditions and attempt to put the odds in their favor by “guesstimating” the probability those conditions will remain intact. Acknowledging that anything can happen helps the argument for hedging given any VIX reading.
Going back to the question, “What’s a trader to do?" In my case it was to buy some more puts since being partially hedged is part of my trading plan going into the weekend. There were, however, steps that could be taken to minimize the IV crush risk on these long options.
Five Things to Consider When Hedging at Relatively High Implied Volatility Levels
- Evaluate expirations to minimize the cost of time, but recognize options with less than 30 days to expiration will really lose value with an IV crush due to accelerated time decay.
- Evaluate collars or hedge wrappers (short call + long put) in place of simply long puts to off-set the costs of insurance.
- Play around with options pricing tools like the ones in Optionetics Platinum to quantify potential losses given changes in IV and time to expiration. This may help you determine the extent of the hedge.
- Evaluate in-the-money long options along with at-, near or out-of-the money options.
- Don’t kick yourself if and when the IV crush creates losses in the long options.
Item number three isn’t really optional, if a sound plan requires partial hedging on a regular basis you should anticipate a certain loss of value due to IV declines along the way.
Current Conditions
A quick assessment of current conditions for the markets is slightly hindered by the holiday. Volume is often needed to fuel the recent moves we’ve seen, but it typically is light around a holiday. That makes the use of volume to confirm or question a move this difficult. In these abnormal markets, we are seeing a somewhat normal holiday scenario:
- Volume is lighter,
- The net change for the broad market averages was relatively small two days before the holiday, and
- Implied volatilities partially reflect this overall decreased activity.
More of the same are expected for Wednesday and Friday, but nothing is guaranteed. One important thing to note is that advances under such circumstances need to show they have some power behind them once normal conditions return.
The study referenced earlier has a nasty title and explores derivatives more exotic than standardized equity option contracts, but the result remains relevant. Titled “Financial Modeling in a Fast Mean-Reverting Stochastic Volatility Environment” by Jean-Pierre Fouque, George Papanicolaou, and K. Ronnie Sircar, the paper explores derivatives pricing in light of changing volatility. This contrasts the constant volatility assumption used in the Black-Scholes option pricing model, as well as the Bjerksund-Stensland American Model used in Platinum.
Happy Thanksgiving and I truly hope you’ve been able to weather these markets well.
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Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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