Option Outlook 2012

12/12/2011 12:01 am EST

Focus: OPTIONS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

As has been the case nearly every year since the inception of listed option trading in 1973, I expect option volume to increase again in 2012 as traders continue to learn about, and benefit from, the two most prominent aspects of option trading: 1) limited risk for speculators and 2) protection of stock portfolios for investors and institutions alike.

Moreover, the newest option asset class–volatility–will continue to grow. The listing of options and futures on the CBOE’s Volatility Index (VIX) has been a tremendous opportunity for traders, and particularly for investors, to be able to hedge the volatility risk in a portfolio or to hedge general market volatility risk. These derivatives have spawned, and will continue to spawn, other volatility products–particularly ETFs and ETNs, which themselves often have listed options. These ETFs and ETNs trade the VIX futures as their underlying asset.

As for market conditions in both stocks and options in 2012: I expect volatility in 2012 to initially remain high for a while, although the extreme volatility levels of the fall of 2011 will not likely be repeated. This relatively high volatility should bode well for option speculators, because there will continue to be plenty of movement in underlying stocks. Also, sellers of options will be pleased as well, as they continue to receive ample premiums from their option sales. However, by March or so, volatility will likely begin to decrease as a more sustainable bullish market environment unfolds. 

These volatility movements will be aided by the typical market seasonality of the four-year cycle, where the stock market typically rallies during the election year, peaking in the year after. A rising market normally entails declining volatility, and that will probably be the norm–modulo small market corrections–during the last half of 2012.

What strategies will work best in this type of environment? It depends on what you’re looking for, I suppose, but I favor a strategy of selling puts outright or as credit spreads–which will be expensive as long as volatility remains somewhat elevated. These could be puts on stocks or on the broad market indices. Risk can be limited by selling put spreads–i.e., credit spreads–instead of merely selling puts outright. Or one can hedge the put sales by owning volatility (buying VIX calls, specifically) as protection in case of a sudden market collapse.

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