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In a sideways market the easiest way to make money is to sell options.
- Jon Lubow |
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Today's Featured Article
A byproduct of the sub-prime crisis that first emerged in late February of 2007 has been the dramatic increase in volatility. This increase in volatility has caused option premiums to increase, and therefore has provided a dynamic opportunity for option traders who like to sell options and collect premium instead buying options and paying premium. In this article I will make it clear to all how much the premiums have increased since last February by comparing the options values on the S&P500. I will explain the Volatility Index (VIX) and then give you real time trade recommendations for selling credit spreads on the S&P500.
VIX
First, it is important to understand volatility and how it is reflected in option premium. Simply put, a highly volatile market is one characterized by rapid change and uncertainty while a low volatility market is one characterized by slow and small changes over time. In 1993 the Chicago Board of Trade (CBOT) introduced the Volatility Index (VIX). This weighted measure of implied volatility of a variety of at the money options allows one to gauge volatility in the market. In addition, the VIX serves as an investor fear indicator: if the VIX is relatively high that is a reflection of relatively high investor fear and uncertainty, while a low VIX shows a high level of investor confidence
in the market. As you can probably guess, a high VIX means high premiums and a low VIX is reflected in low option premiums.
COMPARING HIGH AND LOW VIX AND HIGH AND LOW PREMIUMS
A great way to see the difference in volatility and premiums is to make a comparison by looking back to a specific point of low volatility and thus low premium and comparing it to current levels. To make this comparison it is important to choose a date prior to February 27, 2007. On that date the S&P500 fell 50 points as the news broke that there might be a problem in the sub-prime mortgage industry.
In trying to pick a date from the past that accurately illustrates the volatility and premium differences I have chosen to look at the closing prices from January 26th, 2007, approximately 1 1/2 years ago. On January 26, 2007 the VIX closed at a value of 11.13. For the five-month period from early October, 2006 through February 26, 2007 the VIX traded in a very tight range between a low of 9.39 and a high of 12.83. During this time the S&P500 moved slowly but steadily higher and investors were confident in the market's outlook.
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In March 2007, as things looked less certain, the VIX reached a peak at 21.25. In the 14 months since February 26, 2007 the VIX has never gone as low as 11.13. In fact, it reached a peak of 37.57 on January 22, 2008 and has been trading on average between 19 and 29 for the last 6 months. As of the close of business on April 29, 2008 the VIX was at 20.24.
 If you cannot view the VIX Chart, go here.
I think it is clear that volatility jumped significantly at the end of February 2007 and that we have been in a new era of higher volatility and uncertainty ever since. Now let's take a look at option premiums before the jump in volatility and compare them with current premiums.
On January 26, 2007 the S&P closed at 1422. On that date the April 1330/1370 put spreads closed at 4.5 points. This 40 point spread was 52 points or 3.6% out of the money with three months left before expiration. At the same time the June 1225/1275 put spread closed at 2.85 points. This 50 point spread was 147 point or 10.3% out of the money with 5 months to go. Now let's make the surprising comparison to some similar spreads based on today's prices. On April 28, 2008 the S&P500 closed at 1397, which is 25 points lower that on January 26, 2007. The July 1300/1340 put spread, which is a similar distance out of the money and in time closed at a value of 9.2 points, more than twice the
value of the April put spread above! The September 1200/1250 (similar time and distance as the June spread above) closed at 7.9 points, almost three times the value!
As you can see, current spreads at similar distance out of the money and in time have much higher premiums than the same spreads from early 2007. Now I will show you how much farther out of the money we can sell spreads this year and get similar premiums. The July 1220/1260 put spreads closed at 4.6 points. This spread is 85 points or more than 6% farther out of the money than the April spread from last year. The September 1075/1125 put spread closed on April 28th at 3.3 points. This spread is 125 points or 9% farther out of the money than the June spread from last year.
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The point should now be very clear. Premiums are high, and now is the time to be selling options instead of buying them and paying the high premiums. Below I have outlined the trades I would recommend today along with the initial margin requirements.
Although the VIX is below 20 for the first time since December we are still seeing relatively high volatility reflected in option pricing. I think it is a great time to sell credit spreads while the premiums are still good. You might think that I would be reluctant to sell call spreads based on the recent optimistic tone in the market, but I do not see this market as a runaway bull and still like selling some out of the money call spreads along with the put spreads. To keep an upward bias you can sell 2 call spreads for every 3 put spreads.
The following are the spreads that I would recommend selling today. All prices and margins are based on the close of business on April 25, 2008.
Sell June 1230/1270 put spreads
Premium: 3.80 points x $250 = $950
Margin Requirement: $2,400
Expiration Date: June 20, 2008
Sell June 1490/1520 call spreads
Premium 3.85 points x $250 = $962.50
Margin Requirement: $2,850
Expiration Date: June 20, 2008
Sell 2 call spreads and 3 put spreads
Premium: 19.1 points x $250 = $4,775
Margin Requirement: $6,350
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About the Author
Mr. Jonathan Lubow
graduated from Dartmouth College in 1989 with a BA in History. He has had uninterrupted registration with the National Futures Association since 1990. Prior to co-forming Trader's Edge in 1998, he was the number one broker for his firm for five straight years. At Trader's Edge, a commodity brokerage firm in New Jersey, he maintains the position of vice-president while still trading and servicing customer accounts.
Mr. Lubow is married with two daughters and resides in Morris County, New Jersey. |
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Special Message from Our Author
COMPLIMENTARY Booklet: Smart Trading Techniques
Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now! |
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