From the March 2013 issue of Futures Magazine • Subscribe!

What can a trader do in an exceptionally low-volatility environment?

Options Strategy

Question: What can a trader do in an exceptionally low-volatility environment?

Answer: Sell a VIX put spread and buy an SPY put.

January 2013 was the cruelest month for options traders who enjoy trading volatility from the long side. As of Jan. 29, 2013, the market had a slow and steady year-to-date gain of more than 6%.The biggest one-day move was the first trading day of the year, Jan. 2. The SPDR S&P 500 ETF (SPY) closed at $146.06, $3.65 higher than the Dec. 31, 2012 close. Since that time the highest one-day move of $1.16 was from Jan. 9 to Jan. 10. The largest intraday move in January has been a similarly anemic $1.27 on Jan. 17.

So how can a volatility trader find an edge in this environment? With a combination of tools — but key is the Volatility Index, or VIX, which is priced off of the time value that is embedded in S&P 500 index (SPX) premiums. Time value is 100% of the premium in out-of-the money options. However, with in-the-money options, time value is the additional amount above the in-the-money portion. For example, SPY Mar 149 calls are trading at $3.02 with SPY at $150.54. That breaks down into: $1.54 is the in-the-money portion of the premium while $1.48 would be the time value. When stock prices rise, the price level of the time value that is embedded in option premiums plummets. There is a greater than 80% negative correlation between SPX (or its close cousin, SPY) and VIX. When the stock market rises, it generally grinds its way up, but when it falls, it usually does so very quickly. January 2013 has been a perfect case in point. 

Out-of-the-money calls have a very low level of time value because it takes so long to reach the strike price. Typically they have expired by the time the price level is reached. However, the out-of-the-money puts can reach their strike price in a couple of days. With SPY trading at $150.54, the SPY Mar 146 puts are offered at $0.98 while the equidistant out-of-the-money SPY Mar 147 calls are priced at $0.31, less than one-third the value of the puts. 

Our January time period is a great example of how to understand and utilize VIX. On Jan. 18, the VIX traded as low as 12.29, and at the end of January it was at a little higher at 13.97. This is dramatically lower than as recently as August 2011 when the VIX traded at 48.0. (See “Leveraging the VIX to spot trend changes,” page 24.) The best way to trade the VIX is to trade the options based on VIX futures or the futures themselves. In late January, the February VIX futures were trading at 14.60, March at 15.35, April at 16.15, May at 16.85, June at 17.50 and July at 18.15. Volatility, unlike price direction, always has a reversion to the norm. That is why the futures prices are consistently higher the further out on the calendar. With the VIX at rock bottom, it makes sense that expectations are that the VIX will rise. On Jan. 18 the VIX closed at 12.46 with SPY closing at $148.33. On Jan. 30 with SPY trading more than two points higher, the VIX was trading at 13.88. The VIX, it appears, was oversold. 

If you believe the VIX has bottomed, a sound strategy would be to sell the VIX Mar 15 puts at 1.35 and buy the VIX Mar 13 puts at 0.35 for a credit of 1.00. The futures price and the index converge the closer it gets to the settlement date. You also could purchase the SPY Mar 144 puts at $1.03. If the VIX Mar futures close above 15.00, the vertical put spread will expire worthless. The 1.00 will wipe out all but $0.03 of the SPY put purchase. Anything below $143.97 in the SPY will be pure profit. A 5% down move would place the SPY at $143.02, for a profit of $0.95. The worst that could happen is that the Mar VIX futures settle at 13.00 or lower. That, in addition to the SPY Mar 144 put at $1.03, would result in a loss of 2.03. 

If you have a large long-only portfolio, this strategy would be well worth the risk. You also have the wind at your back if you approach it from a purely trading standpoint: If the VIX were at 21, this strategy would not make sense. Another way to view the trade is to look at it before expiration. If that 5% down move happened within the next two weeks, the vertical put spread would not be worthless but it probably would be worth only $0.15, while the Mar 144 put could easily be worth $5.00 with the sharp rise in time value that would take place with such a drop in the market.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at

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