Signal: Scoop Up Options Now, Regardless of SPX Direction

Yahoo

6 days ago

With the S&P 500 Index (SPX) hitting new all-time highs recently, the Cboe Volatility Index (VIX ) has dropped to its lowest level since mid-February. This isn't unexpected, as the VIX tends to move in the opposite direction of the S&P 500. The VIX is the implied volatility of the S&P 500 over the next 30 days, based on options pricing. The 30-day VIX futures, however, have not fallen as fast as the VIX. Currently, they are trading about 15% above the VIX. In other words, VIX futures traders are expecting a significant increase in the VIX over the next 30 days. Note that the 30-day VIX futures are being calculated using a weighted average of the first and second month VIX futures.
The chart below tracks the S&P 500 back to 2017, with orange markers highlighting times that the 30-day VIX futures were at a 15% premium to the VIX. Eyeballing this chart, it seems this signal occurs during uptrends and at short-term peaks. In this week's article, I'll quantify what typically happens after these signals to get a better idea of what may lie ahead.
The three tables below summarize S&P 500 returns over the next two weeks, one month and three months. I break the returns down by the 30-day VIX futures relative to the VIX. Recently, as previously mentioned, the futures sit about 15% above the VIX. Stocks have underperformed in these situations at each of those time frames. For example, over the next month, when the VIX futures were at this level above the VIX, the S&P 500 averaged a return of 0.50%, with 65% of the returns positive. When the premium was below 15%, the index averaged a return of 0.91% and when it was negative (the VIX is above the futures), the index averaged a one-month return of 2.37%. In our current situation, the magnitude of the average positive return and average negative return is low compared to the other brackets. Based on this, it wouldn't be surprising to see low volatility and underperformance in the short-term.
I ran the same analysis as above, but I wanted to see anything changed if I only considered times the S&P 500 was within 2.5% of an all-time high, our current situation. The table below summarizes the one-month returns. Comparing the average returns in this table to the 1-month returns in the table above, it shows the S&P 500 has lower returns in the first two rows of the data. When the VIX futures premium is in the most normal range (0% - 15%), the average return of the S&P 500 goes from 0.91% anytime down to 0.58% when the index is near an all-time high. Our current situation -- in which the VIX futures premium is high -- the S&P 500 has performed better when it's near an all-time high compared to other times. The average return over the next month goes from 0.50% anytime to 0.59% when near an all-time high.
Since the VIX is a measure of option prices, I thought it was appropriate to see how options have performed on the index in these situations. For this, I'm using hypothetical options on the SPY (an S&P 500 based exchange-traded fund (ETF) with extremely liquid options) which are at-the-money and expire in exactly one-month. So, these are option returns corresponding to the 1-month S&P 500 returns above.
The table below shows how one-month call options have performed on the SPY since 2017 based on the 30-day VIX futures premium. With the strong market overall, call options have been outstanding. Interestingly, the average call option returns are very similar across all three buckets even though the S&P 500 itself tends to underperform with an elevated VIX futures premium. This is because the high VIX premiums primarily occur in low VIX environments. This means options are cheap and a smaller move is necessary to generate a similar return for an option. When the VIX futures premium has been above 15%, call options have had the highest average positive return of 135% and it also shows the highest percentage of option returns that doubled, although all three brackets are similar in this regard.
Next, I show how 1-month put options have performed since 2017. As expected, given the strong market and the call option returns in the table above, puts have been bad. The median return of -100% for each bracket means that the index went higher over half the time and since these are exactly at-the-money options, that results in a complete loss for put options. Put options have been bad bets in general since 2017, but especially when the VIX was above the VIX futures (a negative VIX futures premium).
This last table shows the performance of purchasing SPY straddles based on the VIX futures premium. A straddle means purchasing an at-the-money call option and put option so that you can profit no matter which way the index moves. However, to earn a profit, the move must be significant so that it can cover the premium of both options. Straddles have been profitable on average since 2017 when the VIX futures premium were at current levels. It was only when the VIX futures premium was negative that straddles were not profitable on average.
In conclusion, while the current data suggests low volatility going forward, that doesn't means options will be a poor trading vehicle. In fact, option prices already reflect low volatility expectations. As the analysis above shows, options have historically performed well in similar environments, especially when VIX futures traders are pricing in a significant rise in the VIX over the next 30 days.