Trading Options in a Low Volatility Environment

06/10/2014 8:00 am EST

Focus: OPTIONS

Bob Lang

Founder and Chief Analyst, Explosive Options

With the VIX continuing to register record lows in a market that is simultaneously notching record highs, options trader Bob Lang of ExplosiveOptions.net offers words of caution.

For many traders, it’s been tough to keep pace with the upward trend of the markets. Options trading makes it a bit easier, but with little market volatility it means option prices are cheap—and that’s a double edged sword—more on that below. In short, you really have to learn how to trade options in this kind of market, or you could get burned.

It seems like new all-time highs are registered almost daily in the SPX 500 and Dow Industrials, yet we still hear a chorus of naysayers stating that markets cannot continue to go up, traders are becoming complacent, eventually we’ll pay the piper, etc. Despite these warnings, the markets continue to fly higher. (Bull markets are always treated warily, by the way. Nobody wants to be left behind, and those on board are constantly looking for a place to jump off.)

We will start to hear more about the VIX this week as it reaches a multi-year low (under 11%). Volatility at that level sure smacks of complacency, but as the markets rise to new heights, it doesn’t seem to matter. While we could be due for a breather and some backing/filling, the next dip could be a huge moment for sidelined buyers to step back into the fray. Late to the party? Sure, but until we have signs of institutional selling (that’s the signal to buy), then the trend is your friend.

Now, about the price of options in this market. Low market volatility means inexpensive options, which means the cost of buying some insurance (puts) is also inexpensive. Remember: This is insurance against a catastrophe, like a sudden, deep market correction. From my vantage point, it is highly unlikely such an event will occur in the next 30, 60, or even 90 days, but an unforeseen event could change that posture quickly. In the meantime, we have a market that continues to move upward in the face of doubt, aka, the proverbial “wall of worry.”

As you know, I prefer to let the market tell me how to proceed. The IBD changed its market status to “confirmed uptrend” just under two weeks ago; it had been “market in correction” for nearly 2 1/2 months. They are seeing what most of us technicians are seeing as well—market strength should be respected.

Case in point: Take a look at the IWM chart below. There is a clean break following the recent consolidation on good volume. What is most interesting is that many analysts were saying last week’s consolidation was going to lead the markets lower, while the opposite appears to be happening.

chart
Click to Enlarge

This broad index has flexed its muscle and joined the crowd, and now it’s only 4% off all-time highs. That’s what markets do—zig when everyone wants to zag. Let’s address the question on everyone’s mind: Is it too late to join the action? I don’t believe so, but let’s see how things materialize. We could be back to a “buy the dip” mentality, and if that is true, then we’ll see prices rise as many more jump on board. Just be ready to protect your portfolio!

By Bob Lang of ExplosiveOptions.net

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