How to Trade the Next Big Move in the Stock Market
Over the past few weeks, one thing has become clear to investors in the stock market. Volatility is an inherent part of stock market investing. This has always been the case but 2017 was a year of unusually low volatility and that means some investors may have forgotten what volatility can do to an account.
Volatility is widely associated with fear. This is because the most widely publicized measure of volatility, the Cboe Volatility Index or VIX, is often called the “fear gauge.” VIX is called the fear gauge because VIX rises when the stock market declines and market declines are times when investors are fearful.
The long term chart of VIX using monthly data is shown below. Even the recent move in volatility is relatively low in this view.
The next chart shows more detail of the recent action. The recent spike is extreme based on history, reaching levels seen in the bear market that ended in 2009.
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At its recent high, VIX topped 50, an unusually high level. However, we have seen it reach this level before during bull markets. In fact, the last time VIX crossed above 50 was in August 2015. This was not an official bear market, however it was a time of distress for many investors.
Looking at History
To be considered a bear market, the price of major market averages must fall by at least 20%. In August 2015, the S&P 500 fell 15%. Investors at that time may not have been confident just because the price didn’t fall 20%.
The next chart shows the price action at that time. Two swift declines, the second months after that VIX spike, left investors shaken.
Based on history, it is likely that we will experience more volatility in the stock market. Using the market action from 2015 as a precedent, we could expect a price decline. However, earnings are rising and tax reform could provide reasons for more gains. Both the bulls and bears have strong arguments.
At times like this, it can be difficult for traders to determine which side of the argument they are most comfortable with. Fortunately, there are options strategies that allow traders to benefit from a market move without needing to take a directional bias.
A Long Strangle Benefits From a Large Move
The long strangle involves buying an out of the money call option and an out of the money put option, both with the same expiration date. This strategy can be used when a significant move in a stock is expected. This strategy can benefit from a large move, without requiring the trader to form an opinion on the direction of the trade.
Like all options strategies, the long strangle is limited by time because all options have an expiration date. This strategy can be implemented when earnings are due since the date of that event is known. It provides potential gains based simply on the move.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The timing of the expected move can be difficult to determine. For many stocks, the strangle could be opened in the days before an earnings report is released. This would be a short term trade and options are well suited to short term trades.
Options are also suitable when traders are uncertain about the timing of an expected move. With an index such as the S&P 500, there is no way to know when a large move will develop. Options are also well suited to this time frame since there are a variety of expiration dates available to traders.
A Specific Trade in OEF
To trade a stock market index, it can be useful to remember that indexes tend to move together. While a trade in the S&P 500 could be profitable, it could also be expensive. Long term options to open this position could cost $3,000 or more.
An alternative for smaller investors could be options on iShares S&P 100 ETF (NYSE: OEF). OEF is trading at about half the price of SPDR S&P 500 ETF (NYSE: SPY). That makes the options less expensive.
An out of the money call is one that has an exercise price above the current price of the stock. An out of the money put is that has an exercise price below the current price of the stock.
For OEF, a strangle can be created by buying a $125 call and a $110 put, both expiring on December 21, near the end of the year. The call is trading at about $5.00 and the put is trading at about $3.00.
To open the trade, a total of $800 will be required since each contract covers 100 shares. This example ignores commissions because they should be quite small, just a few dollars, at a deep discount broker. When trading options, it will be important to select a broker that offers very low commission rates.
The trade will be profitable if the index moves by at least 10% at any time before the options expire. The likelihood of such a move is fairly high. The next chart shows that the ETF almost always shows a 40-week rate of change greater than 10% or less than -10%. Either would make this trade profitable.
The risk of the trade is limited to the amount of money paid to purchase the two options. Even if OEF fails to make a large move, the size of the loss could be smaller than the amount invested assuming one of the options retains some value.
When news points towards potential volatility, the long strangle strategy offers a way to benefit from volatility rather than attempting to make directional calls on trades. This could be appealing to risk averse investors who understand the difficulty of forecasting short term price moves.