Asset classes almost across the board have seen a historically boring few months as far as volatility is concerned. Although headline equity indices such as the S&P 500 — as represented by the popular SPDR S&P 500 ETF Trust (NYSEARCA:SPY) — and thus some very large-capitalization stocks have pushed higher year-to-date, the move has come on less and less volatility.
This has market participants (including yours truly) increasingly skeptical.
On one hand, this low-vol environment is providing significantly fewer trading opportunities.
But volatility in recent days has crashed to such low levels that one specific type of trade is becoming increasingly attractive using the SPY ETF and its options.
The implied volatility of options on the S&P 500 — represented by the CBOE Volatility Index (INDEXCBOE:VIX), aka the “Fear Index,” aka the VIX — traded below 10 this week, which historically speaking is a rare occurrence.
Furthermore, although it is true that implied volatility can remain low for an extended period of time and that the VIX is a better indicator for bottoms than for tops, a reading below 10 offers a good opportunity to make bets on an increase in volatility in the not-too-distant future.
On the below chart, we see that the last time before this week when the VIX traded at such low levels was February 2007. I remember it well. The VIX then spiked to 20 in a matter of days.
To be clear, I’m not calling for a massive spike in the VIX in the intermediate-term, but we don’t even need that. I just believe implied volatility won’t remain this low for long.
How can we express such a view in the markets, you ask? Let’s look at the charts and build a trade.
SPY ETF Charts
On the multiyear weekly chart, we see that the SPY ETF — despite its multimonth rise — has yet to touch the very upper end of its multiyear up-trending channel.
Through this lens, there could indeed be more upside in the fund toward $245 and possibly $250.
On the daily chart, we see that on March 24, the SPY gapped higher on the back of the first round of the French elections. Although the S&P 500 has done little if anything since then, it does remain constructively positioned to push higher still in the near- to intermediate-term.
The thing about trading ranges is that they are not resolved until a break in either direction occurs. In other words, I could see the SPY trade higher from here. But until the ETF moves out of this currently tight range, I’m hesitant to take a new bullish position.
At the bottom of this chart, I again plotted the VIX, which really just reflects the complete absence of historical volatility. Furthermore, many institutional investors I speak with have spent much of the year buying puts in the SPY ETF, trying to capitalize on low implied volatility and recently gave up on this trade. This in turn led to another drop in the VIX.
Given my aforementioned view that the VIX is unlikely to stay this low for very long, but also my disinterest in making a new directional bet in the SPY, I’d like to suggest an “at-the-money straddle.”
To execute this, you buy an at-the-money call and an at-the-money put with the same strike ($240 strike currently) using July options. The trade will make money if implied volatility (VIX) begins to increase and if the SPY moves in either direction by a couple of percentage points.
For a stop-loss traders will want to put a time stop on this trade. In other words, if the SPY remains in the current tight range and volatility has not picked up by end of May, cut the trade or roll it out to August or September.
— Serge BergerJoin the $39 Trading Revolution – Plus 1 Month FREE! [sponsor]
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Source: Investor Place