Low Volatility and It's impact on options markets

The front month gold straddle expiring next Thursday can be bought for about 14 dollars. That means you breakeven if it moves 14 dollars in either direction at any point over the next 4 days.

We often hear about “low volatility environments” and how it is bad for markets. But what does that really mean? I am referring to implied volatility, ie the prices of the options. I am telling you that in % terms they are as low as I can remember (not just the short dated) in at least a year. But I think it is important to consider the example of the July at the money straddle above. Looking at the gold chart, you can see that over the course of 4 days we often get 14+ dollar moves, sometimes you get a few, and that makes owning this straddle a very smart buy based on recent history, but still, it gets sold.

Naturally as vol sits on yearly lows, one can say that staying short vol has been a good strategy, but that’s not necessarily true. And here is why.

The person who buys the July straddle at 14 dollars has a maximum loss of 14 dollars. The person who sells it has potentially far greater losses. If the July straddle settles 30 dollars higher or lower, the seller has lost 16 dollars. They lose more than the max loss of buying it on a 30 dollar move. On a 50 Dollar move they lose 36 (lose 50, but took 14 dollar credit). So who would sell it?

We are sitting at 1200, again (yawn, 1200 has become my least favorite number). Gold loves to settle around here. The interpretation that the fed was dovish in its statement helped gold rally over 30 bucks over the course of 2 days, and here we are again. At a place of consolidation, it is natural to see heavy vol selling. While the straddle intuitively seems very cheap at 14 dollars, the seller has reasons to sell.

If you were to create (at expiration of the straddle) a breakeven and likelihood scenario it would look like this.

Seller of 14 dollar straddle makes 14 dollars at 1200. Every dollar it moves away from 1200 by expiration next Thursday afternoon, he loses. So if we settle 1202 he makes 12 dollars (14-2), if it settle 1197 he makes 11 dollars (14-3), if it settles 1100 he loses 86 dollars (14-100). If we could weigh the likelihoods of all of these scenarios, we could figure out what the fair price is.

The reason someone can justify and probably expect to be long term profitable selling this straddle is that we are sitting at 1200. There has been so much consolidation around this number, and so many settlements very close by, that settling right about here is a high likelihood. Therefore, the straddle seller can ascribe a high probability to settlements where he collects nearly the entire amount of premium (the whole 14 dollars if we settle 1200)… 13 if we settle 1201 etc. Based on the amount of movement we see in this market, Selling a 14 dollar seems risky, but the reward is pretty good.

Hopefully this whole example hasn’t been too confusing for those not familiar with options. But I wanted to go through it to try to illustrate what happens as volatility gets lower and lower.

Are you a buyer or a seller of this straddle? You must consider that the amount of capital you have behind you and can afford to lose is probably more important than your actual answer. As a seller, you have the capacity to take losses much bigger than your potential gains. Therefore you need to be very well capitalized. So that the time it does move $100, you will still have the capital to come back and start selling again.

Think about the rift this creates within the market. It essentially takes away the ability of smaller, less capitalized participants to trade from the short side without risking exponential downside. The advent of computerized trading has made “edge” more limited in liquid markets. That “edge” (mispricing of options that allowed traders to buy one option and sell another against it profitably with limited risk) was crucial for smaller players who could make up for the days where the 14 dollar 4 day straddle might not be a buy.

Here is the key thing to remember. The more volatility comes in, the less sellers are getting compensated for their risk. Selling a straddle outright gives you unlimited downside.  There are phones (funds banks etc) that sell straddles and walk away. They are well capitalized enough that they can afford to put up the margin to finance the risk, and absorb the losses should a move happen. Smaller players simply CANNOT trade this way because of the small buffer between collecting small profits and blowout risk. Smaller capitalized firms, locals, and independent traders have to consider that they have limited amounts of capital, and that one swift move, and their career is over.

This asymmetry that results, in which lower capitalized players are really only able to play the market from one side, should be a red flag to market enthusiasts. A healthy market is a market where price discovery is a result of buyers and sellers trading against each other. This market (and liquid options markets at large) are suffering because the players in the market have stood on very different grounds as volatility has continued to come in. What is the result of this? Locals lose money. Gold settles 1200, and the local who bought the 14 dollar straddle just lost 14 dollars. Without the afore mentioned edge trading to finance the losses of buying these cheap straddles locals slowly start to bleed money. The way to stop the bleeding without risking all your capital little is simply to stop trading. And that is precisely what has happened. Smaller participants have left, which only reinforces consolidation of trading into a few big groups, or what I would call an unhealthy market.

I believe that the first rate hike is what is necessary to bring any semblance of volatility back to these markets. When there is more volatility, you will see traders re-entering the market because volatility creates opportunities that are not always so binary in nature (like the straddle being a buy or a sale). My hope is not that a small discount rate raise will cause havoc, but that the money flows that would likely take place as a result lead to some good trading and encourages traders to get back into the market.

For Gold, this 1205 level is pretty critical. A fail here would re-inforce golds downward bias, while a break higher should set up a test of the 1225-30 area, and a break of that should lead to a retest of the 1260 area.