Volatility (both real and implied) has been stepping higher. While not at extreme levels, the S&P 500 Volatility Index ($VIX) is at a precarious point.

Volatility is one of the more reliable market segments for a mean reversion bias. Most of the time, the VIX lives somewhere between 10 and 30. However, when it gets above 30, the index can become very disorderly. The spikes above 30 can be enormous, reaching 50 to 80 in short order (as seen in August 2015, August 2011, and October 2008).

In the 2014 Options Tribe Community Survey, traders were complaining that low levels of volatility were making it difficult to trade neutral strategies. When volatility rises into the upper teens or lower twenties, market neutral options traders find it easier to place and manage their positions. But as volatility rises above this range, market neutral options traders could start to face too much of a good thing.

In my research and trading, I have found it beneficial to use higher levels of volatility to add time and reduce size in neutral trading strategies. The VIX above 20 is a reason to add more time to trades (e.g. 60+ days to expiration rather than 30 days). This helps to avoid Gamma risk from short-term volatility. The VIX above 30 is a reason to reduce size in trades in order to reduce exposure to larger price swings and potential crash scenarios.

With this in mind, there are still edges in being short volatility on spikes and covering those positions on declines. But this best done within the context of the current range. When the range of implied volatility is 15 to 20, then spikes to 20 are shortable and dips to 15 are coverable. When the range is 20 to 30, then 30 is shortable (in smaller size) and 20 is coverable.

Methods to accomplish this would be shorting VXX or UVXY, buying puts in VXX or VIX, and selling premium in SPX.

Shorting rallies in volatility and shorting rallies in price is a good way to play both sides of this bearish market.

-Andrew Falde

No relevant positions. Options risk disclaimer.