High Priced Options: Buy ’em or Sell ’em?

VIX is the CBOE volatility index and is constructed to provide a good measure of the implied volatility for SPX (S & P 500 Index) options.  In general, VIX is an excellent proxy for implied volatility everywhere because when VIX rises or falls, the implied volatility for the vast majority of equity and index options rises and falls along with it.

VIX established another intraday record high (81.17)* Wednesday.  Here's a graph of VIX values for the past few years.  For detail oriented readers, VIX was significantly higher (almost double today's record) during the crash of October 1987, but there are two important items (plus other differences) that should be mentioned.
            *Visit; Change date to 10/16/2008

1) VIX data officially goes back to Jun 1, 1988, but the index value  can be calculated for earlier dates.

2) In those days (prior to 2003), VIX was calculated using OEX (S&P 100 Index) options.  That data is still available (symbol VXO). Today, SPX (S&P 500 Index) options are used to measure VIX.

In today's very volatile markets, there are many more option buyers than sellers.  That extra demand, coupled with the risk involved when selling options, results in higher option prices.  Higher option prices means that the option's implied volatility is higher – as seen by looking at the recent spike in VIX graph.

Some traders buy options to speculate on a continuation of a very volatile market.  Others buy put options to protect the value of a portfolio.  Large hedge funds may be buying or selling as needed to manage their portfolios.  One thing is certain – option trading volume is high. 

One reason for high prices is that option sellers understand the risks they are taking and demand higher and higher prices before being willing to sell.  Thus, VIX increases.

What's an Option Trader supposed to do?

It's reasonable to go with either of these ideas:

  • VIX is so high, traders can easily profit by selling vega
  • The market is experiencing extreme volatility.  Thus, it's best to sit on the sidelines

Most of the basic strategies that I recommend involve positions that are short volatility (as measured by vega – the rate at which the value of an option changes when it's implied volatility changes by one point).  In other words, these strategies perform well when VIX decreases (after the position is initiated) and lose money when VIX increases.  The strategy I discuss most often (at least so far) in this blog, iron condors, is such a strategy.

Thus, the question that should be on the mind of option traders: should you, the buyer of iron condors (or any other strategy that has negative vega), be venturing outdoors, or hiding under the bed? [Reminder: Buying an iron condor means selling one call spread and one put spread in same underlying instrument.]

There are risk-reducing methods you can adopt to protect yourself against large losses, but that protection is not cheap.  The basic idea is to buy a small quantity of extra calls and puts.  This cuts profit potential, but all insurance is costly.

What to do?  The answer depends on your individual comfort zone and tolerance for risk.  The best compromise is to do both; i.e., continue to buy iron condors, but buy fewer.

Speaking for my comfort zone, and trusting that you will make an appropriate decision regarding yours, it's a good idea to buy iron condors, sell credit spreads, or even write covered calls and sell cash-secured naked puts.  But, please be certain you understand the risk of each strategy, and don't accumulate more positions than your comfort zone, and pocketbook, can handle. 

These option prices are high for a very good reason.  Thus, selling options and collecting fat option premium may be very attractive or very frightening, depending on your outlook.  But, there is no easy money to be made here.  Risk management is more essential than ever.


4 Responses to High Priced Options: Buy ’em or Sell ’em?

  1. Steven Place 10/20/2008 at 12:40 PM #

    With this high vol environment I’ve been putting on a lot of Nov/Jan calendar spreads to gain some positive delta exposure, but reducing my risk by taking advantage of the high front month vol.
    It also comes down to what you want to do. If you want to acquire stock outright, then selling puts are good if it’s at an acceptable price level.
    I think selling vertical spreads also work out well as protecting against vol risk.

  2. Mark 10/20/2008 at 12:48 PM #

    I think your statement that it comes down to an investor’s objectives is right on.
    That’s why different strategies work well for different investors. And options are so versatile that there’s something suitable for very investor.
    One comment: Calendars – and I assume you are referring to OTM call spreads here – are a nice way to accumulate long delta. And it’s true that from month vol is exceptionally high, but buying calendar spreads is a vega rich strategy. That means if implied volatility gets crushed, you can lose money on those calendars.
    The front month has a higher IV, but the Jan calls have more vega – i.e., more ‘dollars’ worth of volatility than do the Novs. Just a note of caution.

  3. Robert 10/20/2008 at 5:29 PM #

    I’m confused. Maybe this will simply underscore my lack of understanding. If my policy (comfort level) is to buy ICs with an 85-90% chance of expiring OTM, and I’m always careful that the strikes I sell are, say, 1.7 standard deviations or more away from the ATM strike, won’t I be just as comfortable with establishing a new position when volatility is very high as I was in establishing a new position when volatility was low?
    Actually, I might even be more comfortable in a time of very high volatility because it seems to me that the danger of volatility rocketing even higher away from me would be less than when it’s low.
    NOTE: I’m not sure 1.7 std dev is the exact number that equates to 85% probability, but I do understand the concept and my modeling tool tells me when I’m outside that probability threshold.
    I look forward to your comments.

  4. Mark 10/20/2008 at 8:05 PM #

    Yes, you should be just as comfortable. And it seems to me that you understand this process very well.
    But comfortable or not, we are seeing huge market swings and iron condors were not designed for these conditions. I like the idea of giving back some of the cash I collect to buy a small number of near-term puts and calls for protection. But, in this market, they are sooooo expensive. I’m also willing to trade smaller size as a concession to risk. Are you? ask the risk manager side of your trading persona.
    1) As you know, selling ICs with an 85-90% probability of expiring OTM means selling options with a delta of 5-8.
    2) 1.7 deviations may seem far OTM. With this high volatility, do your short options still feel far enough OTM to leave you comfortable? That’s your decision?
    3) Are you using the current implied volatility to measure the stand dev. If yes, then you are selling options that are further OTM than you used to sell, and that adds some comfort. Especially if you are collecting a similar premium.
    4) I believe that the chances of volatility rocketing higher are small. Yet, weren’t we thinking the same thing when VIX passed 40 and 50 and 60 and 70? I’m convinced that I no longer have confidence ‘expecting’ anything specific and the unexpected (black swan) has made frequent appearances.
    Bottom line: If you are comfortable with your risk and reward potential, and if you don’t lose sleep over your positions, and if they are working well, then you definitely are within your comfort zone and there’s no need to modify your stance. But, don’t get overconfident and please pay attention to risk management.