CBOE’s implied volatility index hit a six-year low this week, so what’s that mean to options trading? Lots, says options trader, Dan Passarelli of MarketTaker.com.
Options trading is greatly affected by implied volatility. At its most basic level, when the VIX is low, it tends to mean lousy options trading.
Option traders are not incented to trade when the VIX is low. Traders generally don’t want to sell options when premiums are so low. There is no reward and still there is always the specter of the risk of an unexpected market shock. And, option traders don’t want to buy options either. Why? Because when the VIX is low, the VIX low is for a reason: Because market volatility is low. Why would traders want to buy options (and endure time decay) if the market isn’t moving?
And so, as always, the devil is in the details. Right now, there actually exists a somewhat atypical pattern in many stock options. Many stocks have their implied volatility trading decidedly below historical volatility levels. Though this volatility set-up can be seen here and there at any given time, it is more common than usual. That means cheap volatility trades (i.e., underpriced options) are more abundant.
That means that even though overall stock volatility (as measured by historical volatility) is low, the options are priced at an even lower level. That means time decay is very cheap per the level of price action in these stocks. And, implied volatility in these stocks (and probably the VIX as well) is likely to rise to catch up to historical volatility levels—assuming the current price action continues as it is.
So, traders should be careful not to sell too many option spreads (i.e., credit spreads) at these fire-sale levels. Instead, traders should look to positive vega spreads (i.e., debit spreads), at least until implied volatility rises offering worthy premiums to option sellers.
By Dan Passarelli, Founder, MarketTaker.com