Playing the Rise in Volatility

With an increase of more than 30 percent in the S&P 500 during 2013, no one can blame the market for being stuck in the trading range this year. After five years of  steady increases, a correction may be approaching soon.

The signals are mixed so far: Although the financial crisis is behind us and the general economy has improved, growth is still only moderate and the international picture is harsh.

Even if you believe there is still fuel in the 5-year rally, the current international picture is grim, especially concerning tensions in the Crimea region. Market prices aren’t factored in a potential escalation in the Russia/Ukraine conflict, as investors believe this is just a matter between Russia and Ukraine. But with the EU and the US continuing to insist on economic sanctions, Russia may retaliate.  That would turn the quiet markets into a blood bath. Volatility is beginning to increase as indicated by the VIX index, currently near 15.5.  But it’s still low for the current situation.

At the current low level of the VIX, and considering the exhaustion of the market uptrend and the negative international picture, it may make sense to play a volatility increase.  This could be done directly through a long position in VIX or through an options position. In fact, options in general derive intrinsic value from the difference between their strike price and the underlying asset price, and from volatility. An increase in volatility favors both calls and puts (long positions). This may be the perfect opportunity to play either a long put alone or a straddle, which is composed of both a call and a put at the same time.

If you believe the market will react negatively to the international conflict during the next few days or weeks, the put alone may give you the upside you’re looking for while representing a limited liability (equal to the option premium). On the other hand, if you believe conflict will be resolved by diplomacy and expect the market to vigorously go up or down, the straddle helps you play this possibility. By buying both a call and a put at the same price, you simply have to wait for the market to go up or down by an amount that covers their premiums. So, if the strike of the options is $1,850 with their total cost being $30, you just have to wait for the S&P 500 to rise above 1,880 or decrease below 1,820.

If you continue to be bullish on the market, and have a portfolio with long equities, a single put on the S&P 500 can help you mitigate the volatility increase after the referendum in Crimea and avoid unnecessary risk.

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