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Option Shrinkage


There are smart ways to position yourself in order to prosper from a drop, or pop, in volatility...


"Do women know about shrinkage? What do you mean like laundry? No, like when a man goes swimming afterwards. It shrinks? Like a frightened turtle! "
Seinfeld, The Hamptons, 1994

Last week, the confluence of benign Producer Price Index and Consumer Price Index reports kicked traders in the pants. Those who were sleeping woke up startled and had the knee-jerk reaction of slamming their foot on the accelerator pedal. Those hanging onto bearish positions were kicked significantly harder, and the more they rushed to cover short positions, the harder the bulls stomped on the accelerator. The net result was the first five-day rally that I can remember in the past six months.

From an option standpoint, a couple things happen when markets rally so abruptly and continuously. For one, rallies tend to bring out those professional traders who are more than willing to sell into rallies, hoping to profit from buying back what they sold at cheaper prices. The second thing that sustained rallies bring is a drop in volatility, which is the trader's perception of risk in the market.

If that seems counterintuitive to you, it should, as a rally feels great when it's under way, but ultimately leaves the market at a higher level -- which logic would tell you has more risk for the bulls than it held at the lower levels. Nonetheless, the reaction of premiums contracting during rallies is not new, but is as regular as the sunrise.

The measure of risk in the S&P 500 is charted by the Chicago Board Options Exchange's Volatility Index (VIX). This measure of risk dropped from Tuesday readings as high as 13.75 to Friday lows of 11.50. That's a contraction of 16% in four sessions and meant both calls and puts were losing premiums as the market was rising.

Rather than just talking about volatility and what a 16.3% drop means, I'll use option prices, as I think they bring the impact across better than any description could. First, let's look at an at-the-money straddle in the S&P 500 September options:

With the SPX trading 1,300, and a (VIX) volatility reading of 13.75 (where it was on Tuesday, Aug. 15), the SPX Sept. 1,300 Calls would trade for $19.30 and the corresponding put options (the SPX Sept. 1,300 Puts) would trade for $19.

When you lower the volatility by 16% to 11.50, the SPX Sept. 1,300 Calls would trade for $16.15 and the corresponding puts (the SPX Sept. 1,300 Puts) would trade for $15.80.

A straddle is a strategy in which you have both a call and a put with the same strike price ($1,300) and same expiration date (September). If you decide to go long each option, you incur a net debit (cost) upfront for the call and put.

Thus, the September $1,300 straddle would contract from $38.30 (in a more-volatile market) to $31.95 (with lesser volatility), a $6.35 reduction in value. Taking into account the bid/ask differential on the calls and puts, the straddle contracted by the same percentage as the VIX, or about 16.3%.

The straddle is a risky strategy, and it depends greatly on the stock making a big movement either to the upside or the downside (as you're protected in both directions), while a small move in the stock generally means the trader would incur a loss. I'm demonstrating this strategy not as a trading recommendation, but as a way to illustrate how higher market volatility results in higher-priced options, which, in turn, cut into your profits if/when volatility eases up.

As you might imagine, when you're caught on the wrong side of a volatility expansion or contraction, it can be painful. Visualize being the bullish investor who buys an at-the-money call to profit from a move higher, only to watch the options lose premium as volatility seeps out. Anyone who's traded knows what that feels like, and I can tell you from one very ugly but valuable lesson that the "death by a thousand cuts" is one of the worst experiences an options trader can be subjected to.

It's important to note that volatility both dips and jumps depending on market conditions. Fear will cause a low-volatility environment to pop to the upside very quickly, just as last week's good news took volatility out. There are smart ways to position yourself in order to prosper from a drop, or pop, in volatility, but that's for another article!
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