Boy, the markets had a rough time yesterday.
The Dow Industrials shed 831 points, which was the third largest ever. That equates to a move of 3.1%.
The Nasdaq got hit even harder on a percentage basis – it lost 4%. That’s a serious move for the tech-heavy index.
And the S&P 500 dropped over 94 points – a move of roughly 3.2%.
It certainly was an eye opener, as we haven’t seen a move like this since early 2018.
But in my opinion, it was well-needed. The markets had been getting a bit frothy and a correction like this was not only necessary, it was healthy, too.
Of course, that doesn’t help when looking at your current account value. I’m sure we all took a little hit yesterday.
But just like the rest of the last 100 year’s worth of stock market history, this too shall pass, and we’ll be heading back higher soon enough.
Let’s Check Those Option Prices
Exactly one week ago, I wrote about the relative “cheapness” of option prices and how buying put options for downside protection could be a very timely investment.
I said that buying protection before the storm was the most opportune time to do it… and that metaphor couldn’t have been more appropriate.
Not only did we get an actual hurricane (Michael) that slammed into the U.S. Gulf Coast yesterday (best wishes to all affected), but we got another type of hurricane in the stock markets.
With the huge sell-off came an incredible rally in the volatility index (the VIX).
Here’s the current chart.
Look at that move over the last week!
The chart I posted in last Thursday’s article had the VIX pegged at a lowly level of 12.
As of yesterday’s close, it had settled at a level of 22.96, an increase of 91.3%! How’s that for explosive?
Volatility is one of the most important components in setting an option’s price, and when it spikes, it drives all option prices higher.
We discussed a hypothetical purchase of the SPY June 21, 2019 $275 put option for downside protection while the SPY was near $291.73 per share.
The put option cost $7.70 per contract at the time. As of yesterday’s close, it was trading for $13.45 per contract. That’s a gain of 75% in one week. The SPY itself closed at $278.30, a drop of 4.6%.
A loss of 4.6% in the index created a gain of 75% in the option. That’s the reason why I love trading options!
This position had two things going for it:
- A decreasing market
- Exploding volatility
When stock prices drop, put option prices rise.
With the fall in the SPY from $291.73 to $278.30, a large move for one week, the put option price popped as it should.
But because the markets made a large move, we can now expect more volatility. And it’s that expectation that can cause option prices to be ramped up even more, even if the larger moves in the markets never materialize.
Who Sets the Price?
The option market-makers are the ones who mostly set the option prices you see on your trading screens. They are required to offer both a bid and an ask for every option that’s listed by the exchange.
If they expect the stock indexes to make larger moves in the near future, they need to hedge themselves by charging more for what people will pay for that protection.
It’s the “expectation” of large moves that helps bump up the option prices.
Just like insurance companies or supermarkets that increase their prices as the storm grows near (or occurring), the option market-makers will do the same.
Regardless of whether the markets keep dropping or not, the option prices will cost more.
And when things start to calm down, the volatility will subside, and the option prices will decline to more “normal” levels.
It’s never easy to predict when a financial storm will hit, but knowing that you can gauge whether it’s cheap or expensive to buy options can literally save you hundreds, if not thousands of dollars for that protection.
Keep an eye on the VIX to give you that advantage.