Trade in Groups

May you live in interesting times.

-Ancient Chinese Curse

Stress in the financial markets has been spilling over into other areas, affecting equities, derivatives, and a wide array fixed income products. Because of their multiple uses and leveraged nature, the equity derivatives market is an especially interesting point of study, because the behavior of numerous speculators and hedgers is colliding in an increasingly uncertain world. There are a number of unusual developments all options traders need to keep in mind, and I was lucky enough to speak with a contact who works the equity derivatives trading desk at a major investment bank many would call the best on Wall Street. Naturally, most of these also have applications to the regular equity markets as well. A few notes, interspersed with my comments…

One puzzle of the options market lately has been the lack of the VIX making new highs as the broader market makes new lows; typically, the VIX moves inversely to the S&P 500. Perhaps more importantly, the VIX is still relatively low even as broader market volatility seems very high; 2%+ moves have become a frequent occurrence. Why, then, is the VIX 30% off its 52-week high when the S&P 500 is setting new lows, and is 21% below its 52-week high? This has to do with many funds becoming net short the market, and thus not seeking protection via purchasing puts. Instead, they are selling stock – which drives the market lower, but doesn’t send the VIX higher. If you think of the asymmetry presented by institutions being net short, it seems the VIX will move lower more easily than it moves higher, because the likely course of action would be to buy calls to quickly offset short positions.
Taking this a step further, I’ve chronicled a number of indicators of market internals and how far into the oversold area they are getting. The noteable exception was the lack of a blowout in the put/call ratios - but this pretty much explains that. If you’re willing to place a contrarian bet, the oversold levels we’re reaching combined with the big money already being net short may lead to a snapback rally in the equity markets on any positive news.

Earlier options articles on this site note that volatility is a component of an option’s price; by being long a call, for example, one is inherently long volatility. While volatility isn’t at an extreme, it’s noteworthy to point out that speculating on a breakout rally with calls has an added risk – being directionally correct and seeing the markets go up, but having those gains mitigated as volatility falls. Better, perhaps, to use a spread strategy – i.e. bull call – to reduce the net long vega. Also, don’t be afraid to step back from the at-the-money options positions into far-into or far-out-of the-money situations; according to this trader, many professional volatility traders have done so because the huge intraday market swings make it difficult to exercise proper risk management.
Everybody wants to think about making money, but it often pays more to think about how not to lose it.