From the February 01, 2012 issue of Futures Magazine • Subscribe!

Using options to exploit an expected spike in volatility

Options Strategy

Question: How do you exploit an expected spike in volatility when you feel it will be only temporary?

Answer: Execute a short strangle swap.

The books on 2011 are closed and as a new year begins, traders ask the ubiquitous question: “What do you think the coming year will bring?”

A compelling argument could be made that volatility is the only given, particularly cosidering recent years. The broad market, as viewed by the S&P 500, rang in 2011 right around 1257 and will begin 2012 about the same. Not very volatile, but that understates 2011’s inherent instability. Keep in mind that at one point in March 2011 the S&P was up nearly 7% (at 1360), and as the fourth quarter began the S&P was right at 1100, down almost 14% on the year and right at the 20% “bear market” decline from highs.

The cash VIX began the year around 17.5 and ended around 23.5 (up nearly 35% year over year). In short, there is greater trepidation as we begin 2012 than a year prior, but VIX trading around 23.5 may understate actual volatility over the coming months. It bears pointing out that the range on the VIX in 2011 was greater than any year in recent memory, with the exception of 2008.

In late April, after fears of a global contraction following the Japanese earthquake and tsunami abated, the VIX traded below 15, a level of complacency we haven’t seen since mid-2007. By early August, however, as concerns over European contagion spiraled, the VIX traded as high as 48, a level only surpassed in the fall of 2008 after the Lehman Brothers collapse.

Against this backdrop, it is likely volatility will spike higher, even if only temporarily. Many, if not all, of the drivers of volatility in the past year remain pervasive threats. Add to the tinder box elections in the United States, Mexico and across most of Europe; referendums on fiscal/monetary policy; unemployment; austerity measures and growth prospects. There seem to be more reasons for spikes in volatility than reasons for volatility to subside.

There are many options strategies of varying complexity that traders can employ in an effort to profit from volatility moves. But a strangle swap allows you to play volatility with distinct expectations for different months.

A strangle swap involves buying a strangle (purchasing both a call and a put) in one month (January, for example) and at the same time, selling a strangle in a different month (March, for example). In this situation, you would be short the strangle swap because you are short a strangle in the long-dated options. Depending on the strikes you use in both expiry months, you either would collect a premium (the position would be executed for a credit) or it would cost out-of-pocket premium (the position would be executed for a debit). For this article, the illustration shows a front-month long strangle with strikes five points closer to the money than the back-month strangle.

A short strangle swap, like the one just outlined, makes sense in a market where you expect a near-term spike in volatility followed by a return to less volatile trade. The goal would be to own the relatively cheap near-term (event) volatility and finance it with a (short) longer-dated volatility position.

This type of strategy affords you flexibility, but also requires tight risk management, particularly when approaching expiration. As is the case with any option strategy, there are no silver bullets, only transfers of risk from and to different areas. If you are long the front-month strangle and short the back-month strangle on our favorite underlying “XYZ,” you are going to be long gamma and your trade-off is you actually are short vega with a negative time decay.

So, what does that mean? It means if your sentiment is that volatility will have a quick move higher, followed by a move lower, the XYZ long January 120 put/130 call strangle and short March 115 put/135 call strangle would be the position to play. “Playing a short-term vol spike” shows the risk reward of such a position. The other key point is being short the back month. You will have margin requirements to think about, as well as what to do if you sell the front-month strangle after a volatility spike, leaving you naked the back month. You can sell the position as a package, or choose to move into an iron condor or diagonal spread; it all depends on what you think the market is going to do, and how your sentiments help you craft your next position.

Michael Cavanaugh is an investment advisor for knowyouroptionsinc.com.

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