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Did You Notice This?

Published on January 10, 2010

Did You Notice This?

January 10, 2010

US Stock market registered a positive 1st full week for the Year 2010. For background, this is a week that is closely watched by market participants for if as goes the 1st week, so is the year; some say that probability rate is greater than 85% (Feel free to dig past data to see the worth). If only markets were so simple to understand; we all know this surely wasn’t the case last year when Dow closed 15% higher vs. the performance of 1st trading week of 2009.

The Dow, S&P 500, and the Dow Transports all closed at new high for the year. So technically, from Dow Theory Standpoint, Markets are now in a continued Bull Market phase.

The most noteworthy news last week was Friday’s December Nonfarm Payroll report which slipped 85,000. It was far worse than economists’ anticipated.  Not all was good. According to Briefing.com-

However, the details of the unemployment rate are not good. The total number of employed workers declined 589,000. Unfortunately, the labor force declined by 661,000 and negated the drop in employment from the unemployment rate statistics. If the labor force had declined by only 134,000 — the change from October to November — the unemployment rate would have increased 0.3 percentage points to 10.3%… Those that do have jobs saw minimal gains in income. The average workweek held at 33.2 hours in December. Manufacturing and overtime hours also posted no change from last month… Average earnings increased 0.2% over the last month as hourly earnings increased from $18.77 to $18.80. Average weekly earnings grew by $1.00 to $624.16.

So all is well till it is not. There is, however, some change in the past few months, that requires little extra attention.

I have been trading volatility for almost as many years as I have been trading options. As an option seller, I enjoyed positive implied volatility skew (I define positive as near term implied volatility to be higher vs. longer term). As an option trader, you could benefit from this positive IV skew by constructing spreads that will allow selling higher priced options and buying cheaper options. (What is implied volatility?).

However, as of now, the situation is totally upside down. The negative IV Skew spread between Feb and Sept ATM options is almost 5%. Here is an example for SPY 115 Puts (% are implied volatility per ThinkOrSwim)-

  • Jan , 13.9%
  • Feb, 15.3%
  • Mar, 17.7%
  • Jun, 19.5%
  • Sep, 20.1%
  • Dec, 20.5%

The above difference is not just for Puts but also for Call options. Pls see attached chart to visually spot the negative skew that I am referring to (Bottom line is Jan’10 options, while the top line is Dec’10 options’ IV).

SPY IV Skew Jan 10 2010

What does this mean? A 5% IV skew for a large index like S&P 500 is something that one needs to be extra cautious about.

Firstly, this simply means that market participants are expecting higher volatility in the long term vs. near term. This uncertainty will transition from front month to back month i.e. as soon as current month completes, IV for the next month will drop (assuming market behaves the way it does currently), while for subsequent months IV might still be on elevated levels.

Secondly, you are buying expensive and selling cheap options (from IV perspective). Thus as an option seller you won’t enjoy the IV advantage.  This change in market dynamics requires a change in option trading strategies; especially if you are an option seller.

While I shall be sharing my thoughts later on I thought to invite your perspective on how are you shifting your option trading strategies?

Interesting times ahead,

Profitable trading, OP

One Comment

  • Avatar Kim Klaiman says:

    OP,

    I think the immediate result for option sellers is increased vega risk. Does it meam that now it’s better trading closer months calendars (feb/mar) and not far months (feb/jun)?

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