Option Trades for Today's Volatile Markets

06/24/2013 8:00 am EST

Focus: OPTIONS

Jared Woodard

Principal, Condor Options

Flatter term structure in option implied volatility is one of the most meaningful indicators of changes in sentiment, says Jared Woodard of CondorOptions.com, and here he talks about what the implications are for traders.

It’s absolutely nuts that implied volatility has exploded higher on such a small decline from recent highs. In the attached video, I explain last week’s selloff by looking at term structure changes in TLT, SPX, and IYR. Note in particular the divergence between IYR and the S&P 500.

20130621-terms from Condor Options on Vimeo.

Flatter term structure in option implied vol is one of the most meaningful indicators of changes in sentiment, because especially for longer-dated comparisons, it takes a lot more to move the needle. These comparisons filter out a lot of noise and tell us more about market sentiment than can be understood by watching one data point (e.g. VIX) alone.

I also show a table of three-month/one-year implied vol term slopes for major ETFs as of Thursday’s close. Values of about 0.9 to 0.97 are typical (depending on the asset) for a normal, bullish market. As you can see, some signs of stress are showing up now. This has some important implications for traders:

  1. If you’re looking to hedge against a further market breakdown, buy premium where it is still cheap relative to the rest of the market. FXI or DIA options are a better value here.

  2. Once the market finds a bottom, short volatility trades will be much more attractive than outright longs. I would even start fading the overreaction now.

Of the major US equity indexes, the flattest term structure can be found in IWM. Traders can buy a time spread here to profit from a return to normalcy in volatility.

By Jared Woodard of CondorOptions.com