Volatility Trading Digest – Strategy & Hedge Ideas

Like the boy who cried wolf, based upon our indicators and Aprils’ recent history of declines, we continue to suggest having conditional hedging plans ready while maintaining long positions in the larger capitalization stocks with good liquidity. Accordingly, we have added a new conditional idea for our favorite hedge ETF below along with an update of our previous VIX hedge idea.

iShares Russell 2000 Index (IWM)

Referring to the comment above, we suggest using a close below 90 to implement this hedge trade suggestion.

First, some options data.

The current Historical Volatility is 11.63 and 11.29 using the Parkinson’s range method, with an Implied Volatility Index Mean of 15.12, down from 16.74 last week. The IV/HV ratio is 1.30 and 1.34 using the range method to calculate the HV. The put-call ratio at 3.20 is bearish, but this is a hedging favorite so higher ratios are normal however, a put-call ratio above 6 would be noteworthy and probably a contrary buy signal. Friday’s volume was 499,401 contracts traded compared to the 5-day average volume of 546,680.

For those who may want to implement the hedge now consider this bearish put spread.

May options with 33 days to expiration were selected since they provide a reasonable balance between gamma, time decay and vega and there is some volatility edge in short May 90 put. Use a close back above the 95 resistance as the SU (stop/unwind).

Of course, if implemented on the condition of a close below 90, it will be necessary to use lower strike prices, such as long the May 89 and short the May 86 however, the implied volatilities will be higher but the short put will still most likely be more expensive in implied volatility terms.

Based on the May VIX Futures price of 14.11 the at-the-money VIX options are the May 14 calls and puts. See the option details in the VIX Options section above.

Since the implied volatility of the VIX options is low relative the historical volatility, as mentioned above a long call position could provide a hedge as the VIX rises with a market decline. However, there is still time decay to consider, so adding a short put position creates a synthetic long and offsets most to the time decay and vega risk.

Here are the details based upon the Friday closing prices. Keep in mind this hedge idea is conditional on an S&P 500 Index close below 1538.57 so the strike prices could be higher than the ones shown below.

May will be the front month Futures contract on Wednesday, the last trading is May 21. At this price, the delta is 1 and the other Greeks are offset. With a Historical Volatility of 83.87, (see above) when it moves to the upside it will do so rapidly requiring close attention.

The suggestions above use the closing middle price between the Friday bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.

As the major headline indexes made new highs, the broader market is lagging as liquidity continues flowing into larger capitalization issues paying dividends. At some point, natural profit taking will overcome the major indexes and the correction will begin so being prepared is the best plan.