July 21, 2017

I love great volatility questions from readers, and here’s one of them:

Q: Aren’t options priced too inexpensively in a low volatility environment? Why would I want to sell them?

A: While we would always appreciate a little more premium (e.g. with the VIX at 13% instead of 10%), we often observe two things in a low volatility environment:

1. Stocks are somewhat stagnant or moving up only gradually. U.S. stocks have performed well this year, but Canadian stocks have been struggling. Creating additional yield and a small hedge via call selling can work.

;and most importantly:

2. When option premiums are this low, actual stock and market movement is typically much lower. Is the VIX at 11% cheap? No, not if the market is moving at 5%. In other words, an 11% VIX tells us that options are implying that the S&P 500 Index will move 0.68% a day. However, the recent historical movement of 7% means it is actually moving at only 0.44% per day. In this scenario, the insurance seller wins and option selling wins. In fact, this spread between option pricing (implied volatility) and actual movement has been very wide this year.

Indeed, funds that specialize in being long options (and therefore require movement in the Index) have performed poorly so far this year because, despite option pricing being low, it’s just not low enough.

We must understand that option pricing is similar to insurance pricing – it is a relative value product. If risk is lower, then lower pricing is justified. In this case, it is still rich versus underlying market movement – with the advantage going to call selling.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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