June’s Low-Volatility Grind Provides Options Trading Opportunities – Schaeffers Research (blog)

The following is a reprint of the market commentary from the June 2017 edition of The Option Advisor, published on May 25. For more information, or to subscribe to The Option Advisor — featuring 10 new option trades each month —  visit our online store.

The summer months in the stock market are somewhat notorious for sluggish price action. And last year’s Brexit shock notwithstanding, the upcoming month of June typically lives up to this stereotype in superlative fashion.

Looking back over the last 50 years, the S&P 500 Index (SPX) has recorded an average return of 0.11% during the month of June. The returns have been fairly evenly split between gains and losses, at 56% positive; the average June advance is 2.39%, while the average loss is 2.79%. That average gain is the smallest of all 12 months — as is June’s standard deviation of returns, at 3.26%.

spx returns by month 0525

Adjusting our focus to daily returns by month, the story remains the same. In the past five decades, the average daily S&P move during the month of June has amounted to 0.01%, with the average gain arriving at 0.64% (tied with July for the smallest average daily positive return). And once again, the standard deviation of returns, at 0.87%, is the lowest of all months.

spx daily returns by month 0525

Corporate earnings season has largely wound down, and consensus expectations are currently pricing in a high probability of a June rate hike by the Federal Open Market Committee (per the CME Group’s fed fund futures) — which points to a generally uneventful stretch directly ahead, in terms of major market-moving events. While ongoing controversies have left a seemingly permanent cloud of uncertainty over the Trump administration, which potentially creates the opportunity for a Brexit-magnitude shock on Capitol Hill in the near future, it’s worth considering that investors have, over the past year, somewhat broadened their capacity for surprise.

And depending upon the frame of reference, the current level of the CBOE Volatility Index (VIX – 9.99) could be accurately described as either low or high — low relative to its own historical average, but high relative to the S&P’s historical volatility, which is hovering around 8 as of this writing. As recently as May options expiration, spot VIX was almost double the S&P’s historical volatility reading — creating a solid premium-selling opportunity for options traders, even as the VIX stayed well below its own 10-year average of around 20.

Note that the VIX high last week (associated with the “Trump Dump” that occurred concurrent with the expiration of May VIX futures options) occurred at 16.30 — on par with the index’s April peak, and in the same neighborhood as half the 2016 intraday high. Last week’s high in this region effectively legitimizes the significance of the VIX 16 level as the site of key volatility tops in the current volatility regime. Meanwhile, VIX 17.01 represents 1.5 times the August closing low. A close above this zone would be a convincing indicator that a lasting VIX breakout may be at hand.

Yet, barring the appearance of any black swans over the next four weeks, it seems statistically probable that we’re on the cusp of a low-volatility grind in the stock market. Given June’s historical tendency to foster a general state of torpor in the stock market, traders might assume the sidelines are the best place to ride out the expected sideways churn. But in addition to the short-term premium selling opportunity noted above, there are also plenty of opportunities for option buyers at present.

That’s due in large part to the relatively low implied volatility readings on individual stocks — which is a fairly widespread phenomenon, now that we’ve emerged from the thick of quarterly earnings season. Low implied volatility levels beget low option prices, and cheap options offer enhanced leverage when trading a directional move (as with call and put buying strategies, including straddles, pair trading, and the like).

So even if the overall market remains muted in the short term, option-buying strategies allow traders to capitalize on individual stock movers by way of the leverage inherently afforded to option buyers (in which the gains on the option play are a multiple of the percentage move in the underlying equity). In other words — in lieu of tying up cash with share purchases (or accepting the steep risk profile and margin requirements of selling shares short), one can reduce his cash outlay and overall market exposure through the purchase of options, while still participating in a stock’s directional movement..

In addition to providing enhanced leverage, cheap options also provide investors a low-cost way to hedge their long stock positions, or a portfolio of stocks (assuming put options are priced on par with call options). Buying protective put option hedges while they’re “on sale” allows traders to limit their downside risk amid concerns over a possible stock market correction, given the degree of headline risk both here and abroad — particularly with major U.S. equity indexes trading around formidable round-number levels.

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