Editor's Note: With this debut column, we're pleased to introduce our newest contributor, Paul Haber, options strategist and portfolio manager at Kramer Capital Management. Paul will be weighing in occasionally with his observations and insights about the options market. We hope you enjoy his work; as always, let us know what you think.
In a historical context, is volatility truly low -- or actually high? The Chicago Board Options Exchange Volatility Index, or VIX, a leading measure of investor sentiment, is at the center of this understandable debate. While some expect the VIX to remain at its recent high levels above 30, justifying high option premiums, they fail to realize that the recent period of heightened speculation was likely an anomaly. In the same way gymnastics judging throws out the highest and lowest scores, the volatility mania from late 1998 to early 2001 should be discarded if we really want to predict where volatility levels should be.
During that period, the average VIX range was 20 to 30. The emotion that fueled the tech bubble of the late '90s also caused implied volatilities to be abnormally high, and dot-com stocks with very small floats provided similar volatility in those issues. This time period marked the dominance of the individual investor, a powerful yet fleeting species armed with a mouse and an E*Trade account, who has since either gone broke or placed his remaining money under the care of professional money managers.
Nowadays, volatility traders are not fully adjusting to the declining volumes and reduced speculative demand in the current marketplace. They're still clinging to hopes that the more recent 20-30 range will become the norm. From 1991-1996, before the tech explosion, the VIX traded in a 10-20 range. How much lower would the VIX be if the current geopolitical environment showed even minimal improvement? It seems more likely that a 15-to-25 range will prevail.
Out With the High Scores
Option Market Makers
Option market-making firms have been crushed by being "long premium" in the first five months of this year and the previous summer. The larger firms have taken huge losses while the weaker firms have been forced to consolidate. Option market makers are leaving the floor in record numbers because volumes are at multiyear lows.
Market-making profitability is largely a function of volume, ideally with a multiplicity of views generating that volume. A market maker can only hedge in an intelligent fashion if a product has enough volume spread throughout different months and strikes. It is much more difficult for them to hedge their risk if the only orders they are seeing are from the large proprietary desks of the world.
The remaining market-making risk managers will likely be gun-shy and unwilling to commit to being long significant premium over the historically quiet summer months. The reduced summer market activity has tended to translate into lower levels of volatility. For example, over the past four summers, the VIX has ranged from 17 to 22.
The risk of being long premium is that the current panic in the market will subside, resulting in lower volatility and reduced opportunities for market makers to hedge their positions. This exact situation is what hurt many firms over the past four summers. The expected lack of floor-buying interest as the current fear subsides could exacerbate the situation and lead to a test of the 20 VIX level.
Summer Trading Strategies
A great way to take advantage of the high current levels of volatility and anticipated range-bound summer is to put on three- to four-month buy writes. Or, instead, write three- to four-month calls against stocks that you already own. The primary goal of call-writing is to maximize your returns when you're neutral to slightly bullish on a stock over a given time frame. Short-term options decay at a faster rate than long-term options and will give you a higher annualized yield. They also provide more portfolio flexibility because of the ability to rewrite more frequently.
A popular alternative is to engage in covered-call writing, but using long-term options rather than short-term options. While this strategy does generate more upfront dollars, downside protection is only a secondary goal of call-writing. As stated above, the primary goal is maximizing your returns over a given time frame. If downside protection were your primary goal, you might consider a collar or a protective put.
Investors who have a range-bound or slightly bullish outlook on a stock over a given time frame would be better off selling covered calls rather than buying naked calls as a form of stock replacement. The covered call is preferable to buying naked calls because time decay works in your favor. Additionally, the large and extended rally necessary to make a call purchase profitable over the summer doesn't seem likely. Many potential events, such as the continued weak dollar, economic uncertainty, sluggish corporate profits and political conflicts, could mute the upside potential and prevent any significant rally.
In summary, summer option writing will help mitigate the risk of investors' positions by doing three things:
- Generating cash flows from a position that they may not want to sell due to tax implications.
Potentially realizing returns above holding the stock during a range-bound period.
Lessening the blow of any depreciation in the stock.
As the market grinds around over the summer, investors will collect nice premiums and enhance the returns of their holdings.
Paul Haber is an options strategist and portfolio manager at Kramer Capital Management, which manages $60 million in hedge fund and other individual accounts and uses equity and equity options to optimize the returns on its portfolios. At time of publication, Haber held no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he
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