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Tuesday's broad selloff caused three interesting things to happen in the market:
1) Option implied volatility spiked, increasing the spread over historical volatility across all the major equity indexes. The first attached chart plots the one month implied volatility of options on the Russell 2000 mini futures against the one month historical volatility of the futures themselves. CBOE Volatility Index (VIX) watchers, remember that there is a VIX-style index for the Russell 2000, published under the symbol RVX.
3) Finally, it's interesting to note what didn't happen skew-wise. As I'll explain at tonight's event, the most meaningful way to measure implied volatility skew is by normalizing the levels of out of the money option IV against at the money IV levels, so that your estimate tracks the actual steepness or flatness of the curve instead of just overall IV changes.
What's interesting about markets this week is that skew did not increase even as the market sold off. In fact, average three month option IV skew in the S&P 500 is actually lower than the levels I pointed out earlier. That's great news for stock longs: if you came into this week unhedged, it's not too late to even out your exposure.
I'm not convinced that the market is making a significant turn lower, but even if this is the start of a major correction, stocks will have to be about this volatile one third of the time over the next month to justify current option premiums. With implied volatility already rich versus stock volatility, correlations back to moderate levels, and skew suggesting that many investors are already well-hedged, I like the odds on a vertical options spread that is bullish on stock prices and bearish on volatility.
Trades: Buy to open IWM June 71 puts for $1.28 and sell to open IWM June 73 puts at $1.70.
I would look to exit this spread if we saw price momentum continue to the downside over the next several sessions.
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