Every Saturday morning my ritual includes grabbing the latest issue of Barron’s and turning directly to the Striking Price column which is regularly authored by a good friend of CBOE Steve Sears, who is credited with coining term ‘fear index’ for VIX. This weekend another good friend of CBOE, Bill Luby the chief investment officer of Luby Asset Management and the publisher of the VIX and More blog site (www.vixandmore.com) was the guest author of the Striking Price column which had the headline “Seizing Opportunity From Volatility”. Needless to say, I was pretty excited when I saw that headline.
Bill discussed the relationship between the CBOE Russell 2000 Volatility Index (RVX) and CBOE Volatility Index (VIX) which is an area of great interest around here. He noted that, as a group, the stocks in the Russell 2000 (RUT) tend to have less exposure to international business trends or other global factors (think China and the Euro zone). He also noted that, based on history of RVX is usually 20% to 25% higher than subsequent realized price volatility for the Russell 2000.
A trade suggestion from the article involved selling a put spread and used last Wednesday’s market action as an example. With the iShares Russell 2000 ETF (IWM) down 1.5% on the day and trading at 121.99, he points out that a trader could have sold the IWM Aug 123 Put at 3.83 and purchased the IWM Aug 121 Put for 3.01 resulting in a net credit of 0.82. If IWM is over 123.00 on August 21st then both puts expire with no value and the resulting profit would be 0.82. The worst case scenario for this trade involves IWM below 121.00 and a loss of 1.18.
When I see an IWM option trade suggestion I automatically think Russell 2000 Index options as there are some distinct advantages to trading index option versus options on stocks or exchange traded funds. Upon returning to the office today I decided to do some digging and see what a comparable trade to this IWM put spread would have looked like using RUT options.
Wednesday of last week the RUT closed at 1228.96 down about 1.5%, just like IWM. Taking a look at standard August options on RUT, the RUT Aug 1220 Put could be purchased for 30.10 and RUT Aug 1240 Put sold at 38.30 and a net credit of 8.20. The risk for this trade involves RUT under 1220.00 at expiration and a loss of 11.80. The goal is for the Russell 2000 to move higher, specifically with RUT over 1240.00 at August settlement. Like the IWM trade from above, this would result in a profit equal to the credit that accompanied implementation of the trade. However, the amount is 8.20 in this case.
When considering both the IWM and RUT put spreads in a risk versus reward context, the payoff for the RUT spread is similar to the payoff for the IWM spread suggested in the Striking Price column, it is just 10 times the size of the IWM spread. This means if a trader took a look at a similar trade and their size would result in a ten lot in IWM, they may be better served looking to do a one lot in RUT. This is dependent on their commission structure, but it is likely the commission associated with trading a one lot in RUT is going to be lower than a ten lot in IWM.
Also, something that differs the IWM spread versus the RUT spread is what may happen at expiration. The goal for each of the put spreads discussed above is that the options both expire with no value. The outcome would be a profit equal to the credit received when the trade was initiated. However, we all are aware that not every trade works out as expected.
If IWM is under 123.00 at expiration a seller of the put spread will be assigned on the obligation to purchase shares. If IWM is under 121.00 at expiration, the seller of the put spread would also purchase shares at 121.00. The point here is if a trader does not want to own 100 shares of IWM, which is the outcome if the fund closes between 121.00 and 123.00 then they will need to exit the spread before expiration.
With the RUT put spread, if RUT settlement is below 1240.00 (the short put strike) the seller of the put spread will make a payment equal to the amount this option is in the money. This is commonly referred to as cash settlement and is a benefit for option traders who want to hold a position through expiration, but not worry about the result being a position in a stock or ETF. With RUT settlement below 1220.00 the seller of the put spread would receive cash equal to the in the money amount of that option. The point here is after expiration, there will be no position in an underlying security. The result is either a net profit or loss equal determined through cash transfers something that many traders would prefer.