Traders of volatility will have noticed that since the bull market began in 2009, overall volatility in the market has been somewhat muted (with a few obvious exceptions).
This shouldn't come as a great surprise, as equity markets have been going up for years now, and grinding uphill markets are usually accompanied by declining volatility levels.
The thing is, no matter the overall conditions of the market, traders still need to find opportunity.
Along those lines, during a recent episode of Market Measures the tastytrade team concentrated on the realities of lower implied volatility environments and explored some research that may unlock new opportunities during extended periods such as this.
First, the Market Measures team examined research from 1990 that revealed the VIX has traded under 15 approximately two-thirds of the time from that year to present time. However, the research also showed that in recent years, the number of occurrences in which the VIX traded under 15 was proportionately higher.
This data is illustrated in the chart below:
Due to the realities of sub-15 VIX environments, the tastytrade research team then decided to evaluate trading longer duration options to help compensate for lower implied volatility. Longer-dated options often trade at a higher implied volatility because uncertainty theoretically increases the further one goes into the future.
An example that helps illustrate this phenomenon is discussed on the show and involves the last two SPY expiration cycles in 2015, as shown below:
- November 2015 (10 days-to-expiration): 15% implied volatility
- December 2015 (101 days-to-expiration): 18% implied volatility
Before actually deploying trades on these longer-dated maturity options, the team also conducted complementary research on the historical success of such trades.
The parameters of this study involved SPY data over the last 10 years and evaluated two different strategies - with each selling a strangle on the 1st trading day of every month when the VIX was below 15.
The two trading strategies had the following unique characteristics:
- Sold one standard deviation strangle nearest to 100 days-to-expiration
- Sold one standard deviation strangle nearest to 45 days-to-expiration
The results of these two strategies are shown below and indicate that the 100 days-to-expiration (DTE) averaged a higher profit and loss over the 10 year period.
It's important to note that the above strategies were tested only when the VIX was below 15.
To delve deeper into the analysis, the guys then re-ran the study, but this time evaluated the two strategies only when the VIX was above 15.
In the second scenario, the results clearly indicated that in higher VIX environments trading shorter-dated options was the more profitable of the two strategies, on average:
While there are many important takeaways from this research, the most important is that traders may need to consider adjusting their approach to duration according to low and high implied volatility environments.
As we can see from the aforementioned discussion, historical data suggests there's an opportunity to trade profitably in longer duration options during extended periods of low volatility (sub-15 VIX).
On the other hand, it's also important to remember that by changing the duration of the trade, from 45 DTE to 100+ DTE, traders also need to consider the adjusted risk ramifications of those potential positions.
Prior to entering longer duration trades, a trader will need to evaluate whether the new dynamics align with his/her risk tolerance and objectives.
Some of the risks to consider in longer duration trades include (but are not limited to):
- Increased exposure to large changes in implied volatility (i.e. more vega risk)
- Lower number of occurrences
- Potential for decreased liquidity
We invite you to watch the entire episode of Market Measures focusing on extending duration in low implied volatility environments when your schedule allows.
We also hope you will contact us with any questions or feedback at firstname.lastname@example.org.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.