The Volatility Tipping Point

by Tyler Craig on August 18, 2011

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Over time I’ve adopted a multifaceted approach to the markets which leans heavily on charting and volatility analysis.  The ideal setup occurs when both are in alignment providing me a one-two combo of confirmation.  When faced with a situation generating conflicting signals I must of necessity make a choice.  Do I yield to the method of analysis which I perceive offers the stronger signal?  Or, do I respect the conflict and settle for the safety of the sidelines?  In a recent opportunity arising in the oil patch I opted for the latter, but hindsight bias has me currently questioning the wisdom of my actions.  I’m wondering if I passed up a “better” decision on my way to a “good” one.

Given the relatively consistent bullish behavior of oil in recent years I’ve been a fan selling puts on the United States Oil Fund (USO).  With few exceptions it’s been a profitable approach.  Though I’ve attempted to employ this campaign on a monthly basis, I’ve generally avoided selling puts when the USO was in the midst of a downtrend.  The thought of course is that if the trend is likely to continue then there is no sense  jumping into a non-bearish bet like short puts.  It is for that reason that I exited my short put position in early August and have yet to re-enter.

Here’s where the conflict comes in.  The recent selling frenzy in black gold and subsequent mad dash into the options mart lifted implied volatility for USO options to levels not seen since the mass oil liquidation of ’08 and early ’09.  Unlike the VIX, the OVX blew way past flash crash levels.  Such a spike presents all sorts of opportunities for short volatility type plays like short puts.  Though the broken uptrend was telling me to steer clear, the elevated volatility was screaming “sell me, sell me”.

I believe there comes a point – a tipping point if you will – when implied volatility gets so pumped and option premiums so fat that there is more than enough compensation to merit short puts or put spreads in the midst of a downtrend.  I suspect we reached such a point last week in the USO. Unfortunately my overemphasis on charting and underemphasis on volatility caused me to pass up the opportunity.

Option sellers should keep this tipping point in mind when future volatility ramps arise.

For related posts, readers can check out:
Strike While the Iron Is Hot
Behavioral Shift in USO

{ 6 comments… read them below or add one }

Dmitry August 18, 2011 at 9:28 am

Why not sell put spreads in those downtrending times? Or maybe play the skew ?

Reply

Tyler Craig August 18, 2011 at 11:29 am

Hey Dmitry,

As mentioned in the post I would only look to sell put spreads once the volatility was elevated enough (and therefore net credit high enough) to justify stepping in front of the downtrend. So given the right environment, yes, you may consider selling them.

Playing the skew is another legitimate idea. Throwing on a 1×2 put spread would make sense.

Reply

MarkWolfinger August 18, 2011 at 1:09 pm

Tyler,
I find it desirable to sell put spreads into a rising IV environment. Obviously, if one does it too early, there is going to be some pain.

Because I never know the IV top, I just slowly scale in. If the market reveres, at least I have some good trades.

Truly an individual decision

Reply

Tyler Craig August 19, 2011 at 10:02 am

Yeah, I like the idea of scaling in. Staggered entries help compensate for the inability to always nail the top.

Reply

Kirk August 19, 2011 at 5:17 am

Short puts are how I prefer to play it…allowing you to get further away and then on the slightest drop in volatility you can go back and buy the long option and create a more “favorable” spread.

Reply

Tyler Craig August 19, 2011 at 10:01 am

That’s an interesting idea as well. If you’re timing is solid I can see how you’re getting more favorable prices.

Reply

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