S&P 500 Index – Low Volatility

March 20, 2010

Although the S&P 500 Index has rallied for well over a year, the volatility in the index has declined considerably.  This means that you should select strategies that benefit from a rise in volatility.

We do not have a bearish or bullish bias on the S&P 500 Index, however, through logical conclusion, it is not unreasonable to expect that a rise in volatility may occur soon.  That being said, studies have shown that financial markets increase in volatility when they are on the decline.  The opposite is true for most physical commodity markets – when they rise, volatility tends to increase.

With this observation in mind, if one believes that volatility is due for an increase in the S&P 500 Index, then it stands to reason that bearish factors weigh in on the S&P 500 Index.

There are many strategies that benefit from a rise in volatility.  Some common strategies are the ratio backspread, calendar spread, strangle and straddle.  Note that some of these spreads will suffer from time decay. However, an increase in volatility will more than offset time decay.  The straddle, strangle, calendar spread and ratio backspread all suffer from time decay.  But note that we are entering positions based on exploitation of low volatility of the underlying market rather than entering them for time decay.  In other words, time decay is trumped by our expectation of an increase in volatility in the underlying market, in this example, the S&P 500 Index.

At the bottom of this article, there is a graphical image depicting a bearish strategy that benefits from an increase in volatility in the S&P 500 Index.

Additional emphasis needs to be placed on the concept that we are not bearish the stock market; however, we know that volatility is extremely low, we know that volatility rises on price declines, and therefore, it would not be unreasonable to structure a position that benefits from a rise in volatility.

As stated throughout this site, we prefer spreads versus outright option purchases.  Option purchases (without spreading) usually end with dismal results.

Notice the increase in volatility that was inserted into the graphical depiction of this strategy. The increase is 6 percent, which is quite liberal, in terms of historical statistical volatility levels.

S&P 500 Index Option Trade

S&P 500 Index Ratio Backspread

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