Harness Increases in Market Volatility with Index Options

Investors tend to shy away from volatility, as market declines typically correlates with incurring losses in a portfolio. While the desire to reduce risk is completely understandable during bear markets, the process to protect a portfolio may not be as straightforward. In this post, we explore how you can harness the volatility as markets turn lower to your advantage and protect a portfolio during market downturns. You can also watch a replay of a webinar that werecently hostedon how to harness the volatility of the market to generate income and navigate a bear market.

Measuring Volatility

Volatility can be measured by using a volatility index such asVOLQ the Nasdaq-100 Volatility Index. It measures the implied volatility ofNasdaq-100 index options (NDX). VOLQ uses the front month implied volatility of at the money NDX options to derive its value. When VOLQ moves higher, it indicates that there is greater uncertainty and that larger moves are expected in the Nasdaq-100. Strictly speaking, implied volatility is independent of direction, however, a decline in the Nasdaq-100 Index almost always correlates to an increase in VOLQ.

Chart 1: NDX vs. VOLQ

Source: OptionsPlay

The chart above highlights the inverse relationship between VOLQ and NDX.

Option Strategies for Volatile Markets

A key component in options pricing is volatility, options are more expensive as implied volatility increases. Thus, buying options become more expensive, negatively impacting the risk/reward. Instead, it may be advantageous to sell options during higher volatility environments as the premium received will be elevated. Moreover, volatility is mean reverting, meaning there is a statistically higher probability that volatility will reverse lower after a spike, reducing the premium of an option even if the underlying does not move. This would allow you to buy back the option sold at a lower price and generate a potential profit.