Harness Increases in Market Volatility with Index Options

Investors tend to shy away from volatility, as market declines typically correlates with incurring losses in a portfolio. While the desire to reduce risk is completely understandable during bear markets, the process to protect a portfolio may not be as straightforward. In this post, we explore how you can harness the volatility as markets turn lower to your advantage and protect a portfolio during market downturns. You can also watch a replay of a webinar that we recently hosted on how to harness the volatility of the market to generate income and navigate a bear market.

Measuring Volatility

Volatility can be measured by using a volatility index such as VOLQ the Nasdaq-100 Volatility Index. It measures the implied volatility of Nasdaq-100 index options (NDX). VOLQ uses the front month implied volatility of "at the money" NDX options to derive its value. When VOLQ moves higher, it indicates that there is greater uncertainty and that larger moves are expected in the Nasdaq-100. Strictly speaking, implied volatility is independent of direction, however, a decline in the Nasdaq-100 Index almost always correlates to an increase in VOLQ.

Chart 1: NDX vs. VOLQ

Source: OptionsPlay

The chart above highlights the inverse relationship between VOLQ and NDX.

Option Strategies for Volatile Markets

A key component in options pricing is volatility, options are more expensive as implied volatility increases. Thus, buying options become more expensive, negatively impacting the risk/reward. Instead, it may be advantageous to sell options during higher volatility environments as the premium received will be elevated. Moreover, volatility is mean reverting, meaning there is a statistically higher probability that volatility will reverse lower after a spike, reducing the premium of an option even if the underlying does not move. This would allow you to buy back the option sold at a lower price and generate a potential profit.

Other best practices to consider during volatile markets are the use of spreads instead of single leg trades to improve the risk/reward profile, as well as scaling in and out of trades with respect to position sizing, as opposed taking an all or none position.

Top 3 Option Strategies for Bear Markets 

Bearish Credit Spread (Bear Call Spread)

This is a neutral/bearish strategy that involves selling an At the Money call option and buying an Out of the Money call option. The investor receives a net credit which also represents the max gain for this strategy. One rule of thumb that we use for this strategy is to only sell a credit spread when the credit received is at least 33% of the vertical width.

• Sell 50 Delta Call
• Buy 25 Delta Call
• 45 Days to expiration
• Max gain = credit received
• Max loss = Vertical width - credit received

This strategy has Theta working in its favor and is also short Vega as a decline in volatility from elevated levels is beneficial for this trade.

Bearish Debit Spread (Bear Put Spread)

This is a bearish trade and should be used for hedging reasons. As debit spreads involve a net debit, the amount paid to use this strategy can be expensive which is why the main motivation for this strategy in a bear market is only to hedge against the broad-based decline in a portfolio. By opening a put debit spread on a broad-based index that correlates to the portfolio holdings, the investor can protect against further declines in the market. However, this can be an expensive strategy, even more so in high volatility environments where options can be expensive which is why this strategy should only be used when the investor expects a significant decline in the market.

• Buy 50 Delta Put
• Sell 20 Delta Put
• 60 Days to expiration
• Max gain = Vertical width - premium paid
• Max loss = Premium paid

Short Unbalanced Strangle

A more advanced strategy that involves selling both a call and a put option. A short strangle is generally Short Delta (works in a neutral and declining market) but can be adjusted to have a directional bias by picking asymmetric Deltas. Selling both an OTM call and put when volatility is elevated can generate a significant premium during bear markets.

• Sell 30 Delta Call
• Sell 15 Delta Put
• 45 Days to expiration
• Max gain = Credit received from selling the call and put
• Max loss = Unlimited

In a bearish market, selling a higher Delta call option (closer to the current spot price) and a lower Delta put option (further away from the current spot price), the Strangle will have a negative Delta and profit if the index drifts lower but stays inside of the breakeven prices. It is generally advised to use this strategy on index options as there is no assignment or exercise risk due to index options being cash settled at expiration.

Utilizing Index Options in Volatile Markets

Index options offer a wide range of advantages and can be used with the strategies above. While the tax benefits of index options are well known, index options can be ideal for navigating turbulent markets. Index options typically offer European settlement and are cash settled at expiration, this eliminates early assignment risk compared to an index ETF option. This can provide an advantage during times of high volatility as early assignment is a primary concern for options sellers.

Additionally index options are also listed on some of the most widely tracked indices. Not only does this offer diversification from single stock risk, but also offers a high level of liquidity which allows for faster execution. As index options represent a group of stocks, there is less earnings risk as well and any gaps at the open tend to be small in comparison to what you may see on single stocks. Our research even shows that liquidity improves during times of market stress and volatility.

While there are many benefits to index options, they can be out of reach for retail traders due to their large contract sizes. With the NDX currently at $11,000, 1 contract would represent 100x the index of NDX which represents a $1.1 million contract, typically too large retail traders. However, indexes like the Nasdaq-100 Micro Index (XND) provide a solution to this.

Nasdaq-100 Micro Index (XND)

The Nasdaq-100 Micro Index (XND) is based on 1/100th of the full value Nasdaq-100 Index (NDX). It tracks the performance of the Nasdaq-100 index just like NDX, but the notional value of the exposure is 1/100^th the size. Ideal for retail traders to access the same advantages of index options with a contract size that is better suited for smaller portfolios.

Image: Nasdaq-100 Index and ETF Options

Source: OptionsPlay

Conclusion

Navigating bear markets with high volatility can be difficult with wild swings in not only profitability but also our emotions. However, options strategies can offer protection in volatile markets while index options can further reduce expiration and assignment risks. Moreover, with the correct process, volatility can be harnessed to hedge against further market declines and take tactical bearish opportunities in the market.

To learn more regarding trading index options strategies during a bear market, please watch a webinar that we recently hosted on How to Harness Increases in Market Volatility with Index Options.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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