The Option Pit VIX Traffic Light Is Yellow: Volatility is likely to move wildly.
The S&P 500 closed down near the lows on Thursday, 44.8 points to 3808.10…
VIX rallied marginally, moving to 22.53.
But that is not what caught my eye on Thursday. It was something else…
There are two major indexes that trade the implied volatility of stocks on the NDX (the QQQ).
There’s VXN, which is the exact same methodology as the VIX but applied to NDX options.
Then there’s VOLQ, which measures the IV of at the money options…it only tracks a few options around where NDX is actually trading and delivers a value…
Comparing the two can give me a very good idea of where skew is trading.
Skew is the cost of out of the money options…primarily puts…relative to at the money implied volatility.
Normally the spread between VOLQ and VXN is about 3 points to VXN…
That spread has been trending downward…but has reached levels that are now borderline insanely cheap.
Check out the spread movement over the last few weeks:
The spread dipped slightly below .5 a few days back, but on a day that the NDX was down 1.6%, the spread actually dropped and is well below 1.
Skew should not be this cheap when the market is selling off, even if it has been range bound lately.
So what does this mean…one of two things:
Either out of the money options are too cheap, or near the money options are overpriced.
So how can you use this to your advantage? Backward puts.
Going back 4 years we have only seen the spread get this tight on a handful of occasions:
It has been an opportunity to spread every single time.
So here is how to do it…
Sell a near the money option…then buy on a ratio of 2 to 1 an out of the money option against it.
For instance…and I am not suggesting you do this trade…but it is compelling…
I can sell the March 255 put in QQQ at 9.15 and buy 2 of the March 238 puts for 4.40 and take in a .35 CREDIT…
The spread looks like this:
I should NOT be able to do this 3 months out…the trade performs even better if skew increases and/or volatility increases…
Food for thought.
Your Only Option,
Mark Sebastian