Dec

5

P McD

In recent months the market has become more volatile. This volatility has led to further evolution in the traditional option to underlying linkage. In many cases we are seeing the option move the opposite to its traditional correlation with the underlying.

For example, the calls on the Russell 2000 index ETF (IWM) sometimes drop when the underlying goes up. Even on days when IWM is up more than 2% the calls will often drop. The reason for this paradoxical behavior is the simultaneous radical change in expected volatility. When the market goes up the VIX will usually fall. The correlation is a powerful -83%. When VIX falls options become less valuable. Specifically we are seeing the VIX effect completely overwhelming the effect of delta.

To trade this successfully one needs both a directional model and an ability to predict volatility. The ability to merely predict direction is no longer sufficient.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Greg Calvin writes:

We have also seen call options hold their value on days the market/underlying is headed down fast. A misplaced sense of comfort may arise in these situations. One needs confidence that the underlying will rebound in the future planned trading time frame, as the IV settles back down and time decay marches on. I have found option spread trading to be one way to [sometimes more than] offset losses on long calls or puts due to IV drops. The sold calls or puts will also drop in value when IV declines. In addition to vertical spreads, calendar spreads can provide opportunities when front month options have significantly higher IV. Volatility tends to increase not only when underlyings decline, but also as announcement events approach. Lagging into spreads as volatility increases is particularly attractive, as the higher IV premium tab gets picked up by someone besides you.

Diego Joachin remarks:

I think options' behavior is the underlyings' subconscious. It reveals the fear of players. That's why studying volatility is more important now.

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