In any given market environment, we do our best to evaluate the risks in our portfolio to prepare/plan for the worst case scenario.
When volatility is low, and we continue to deploy high probability short premium positions, a natural fear is of course that volatility will expand.
While that's certainly a concern from a risk-management standpoint, a recent episode of Options Jive examines historical data that may help broaden your perspective on low volatility trading environments.
As outlined on the show, a good example to think about is a short strangle in the SPY. If you are short a 30 delta strangle in the SPY, your risk is that volatility expands, that SPY makes a big move, or both.
You might even believe that the risk of SPY implied volatility expanding is greater when volatility is compressed (i.e. VIX is low).
In order to better understand these concerns, the Options Jive team ran a study looking at historical data in VIX going back to 1990. The team designed a study that recorded the value of VIX on Day 1 and Day 45, then computed the difference between the two - for the entirety of time from 1990 to present.
To evaluate the behavior of VIX in different trading environments, the team then broke the results into 3 categories:
low volatility periods (VIX < 13)
medium volatility periods (VIX between 13 and 17)
high volatility periods (VIX > 17)
Because the VIX has spent the bulk of 2017 trading below 13, the results from the “low volatility” environment are of particular interest.
Pictured below is the graphic illustrating the results from the study, which showed that on 75% of occasions, the VIX increased less than 2.5 points (over the 45-day period) during low volatility periods (VIX < 13).
The slide above shows that while short premium strategies are always at risk of increasing implied volatility, historical VIX data shows that the risk in compressed volatility environments has been somewhat contained during the majority of instances.
The guys also outline a couple strategic approaches traders can use during these periods to offset adverse conditions, which include:
Reducing contracts and overall size
Skewing trades to short delta, to compensate for short vega
We think this episode of Options Jive focusing on the potential risks of trading in low volatility environments is worth reviewing in its entirety, and hope you’ll do so when your schedule allows.
Another piece that we recommend reviewing is a recent blog post highlighting the importance of being patient when managing a short premium strategy.
We hope you’ll reach out with any questions or comments at firstname.lastname@example.org, or leave a message in the space below, at your convenience.
In the meantime, keep it tasty!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.