What to Do in Low-Volatility Markets

01/17/2013 3:15 pm EST


Don Kaufman

Co-Founder, TheoTrade

We continue to chug along in a low-implied volatility market but it won't always stay this way, so what do you do? Don Kaufman shows you.

One thing traders need to be aware of right now is the low implied volatility and what that means to your strategies.  My guest today is Don Kaufman from TD Ameritrade. So Don, what is low volatility mean for us here and to our trading strategies?

Well, again, what is low volatility? When it pertains to options, so I look at volatility, possibly a little differently than most traders do.  Most traders look at volatility in terms of, for instance, price action.  I would look at implied volatility, which is what options are delivering us right now as implied risk.  I mean, vol again is risk, and with the low volatility in this marketplace, it's breeding a lot of efficiency. 

We're seeing just incredible efficiency, lower risk, again, the implied volatility there, and I really think that at times you get complacent in that. I mean that's what low implied volatility; does it mean all of a sudden that markets are going to possibly sell off?  No, not necessarily, but there will be reversion to the mean.  Implied volatility, sooner or later, it does go back up. 

The risk isn't off the table, and I think everybody gets lulled into that sense of, all right, low implied volatility, the markets have been grinding sideways with some nice upward action as of lately, and listen, we'll see if it continues here, but never fear; volatility always returns.

So it's been argued that maybe I should be considering buying some puts here.  If it's been low for this long, we expect it maybe to rise and markets to sell off a little bit?

See now, trying to time when implied volatility is going to explode, and trying to use implied volatility to pick direction in the markets, it's a really tough bet.  You've got to have your options strategies right; that's one aspect.  Number two in options strategies is going to be the timing of it.  Better possibly to position yourself just being a little bit more risk averse because what ultimately happens in these periods of low implied volatilities, again, you get amazing efficiency. 

When I say efficiency, everything from bid-offer spreads seems nice and tight, and out of nowhere the storm basically descends upon us.  It's not a matter of "If", it's a matter of simply "when," and again, trying to time that, it's like trying to time any other strategy.  You position yourself for periods of higher implied volatility at all times.

All right then, how about then, a LEAP.  Would that argue for that if I'm not sure about the timing, maybe a put LEAP.

Ah, LEAP options, so you're trying to drive me towards a strategy.  You know when you're strategizing around looking for higher implied volatility, very often using things like put calendars and calendar spreads, that's a multi-month spread. 

That is right now you're looking at selling an option that's a little bit nearer term, and buying an option a little further out, and the options further out in time have more sensitivity to changes in implied volatility, and that's a big, very common misconception, so if you were to look into the future you can sell an option, all right, with an expiration; 30 days, maybe 60 days out, and maybe buying an option maybe 90 days out, and it positions yourself for the implied volatility that we could see in the near future.

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