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By Jason Stipp and Erik Kobayashi-Solomon | 06-19-2012 11:00 AM

Want to Strangle the Market?

As volatility ebbs and flows with large price swings, a strangle option strategy could be attractive right now, says Morningstar option specialist Erik Kobayashi-Solomon.

Jason Stipp: I'm Jason Stipp for Morningstar.

With the situation in Spain and Greece still very fluid, we're checking in today with Morningstar OptionInvestor editor, Erik Kobayashi-Solomon to see what's the impacts been on market volatility.

Thanks for joining me, Erik.

Erik Kobayashi-Solomon: Thanks for having me.

Stipp: We continue to get headlines out of Greece especially, but also continuing headlines out of Spain. The market is reacting in different ways to this. What's been happening lately with volatility? What have we seen?

Kobayashi-Solomon: It's been amazing honestly. The last time we talked, volatility on the S&P 500 was trading around 24. The VIX was trading around 24. That's dropped all the way under 18 actually. So, more than a 25% drop in just the last week. And what you can see is, is the group of 20 large powerful countries have said that they would inject liquidity into the market if there are big problems in Greece, and as soon as they made this announcement, you just saw volatility fall right off the cliff.

Stipp: So, despite the fact that we have continued uncertainty in this region, that there's still continued worries about solvency of a lot of these nations, because we think that folks are ready to take action on the policy front, volatility actually has gone down?

Kobayashi-Solomon: Exactly, and this is really along the lines of the story--I saw your video with Bob [Johnson, Morningstar director of economic analysis] talking about good news is bad news and bad news is good news. This is really what that's all about, the Bernanke Put, and expectations for more QE.

Stipp: So, I wanted to ask you about that, because the Fed is meeting again this week. What do you think the market's expectations are for what extent of action we're going to see from policymakers? Is the market expecting just a continuation of some older programs, or are they expecting something even bigger given that the worries from Europe just persist?

Kobayashi-Solomon: Considering that Spanish debt, the yields are trading very high right now, that the economic data here in the United States has been very weak, I really think that the market is not only expecting a continuation of this Operation Twist, but actually a full-blown kind of Quantitative Easing program.

Stipp: So, let's shift and talk about options. So, obviously as volatility moves up and down, there is an effect on option prices. Can you describe what's been happening with option pricing generally lately given these changes that we've seen in volatility?

Kobayashi-Solomon: Sure. So, I just mentioned that the VIX really came down over the last week, and basically what that is doing is it's implying a much narrower kind of range of outcomes for the S&P 500. You can see this very clearly on a diagram. Last week, that cone of possibilities was very, very wide. This week, it's thinned down a lot, and it'll maybe even get skinnier still.

Stipp: So, although that cone is smaller, it changed very quickly, so would you say it could just as easily pop back open again if we start to see policymakers having disagreements about what to do, or programs that might get stalled?

Kobayashi-Solomon: It could, indeed, and in fact, I just did a study looking at what the VIX did over the summer months. There is the saying in the stock world, sell in May and go away. Well, in the options world, it's actually better to buy in May and go away.

Stipp: So, why is that? Why is it better to buy in May, if you're an option investor?

Kobayashi-Solomon: It turns out that, as we've talked about before, as the S&P goes down, if stocks really do sell off in the summer months, then the volatility should increase, and indeed looking at 22 years worth of data, the average increase is about 18%. So, you maybe buy an option and just expect it to increase because of that increased volatility.

Stipp: And what about those times when we actually see the market do well in the summer months--does that have the effect of having volatility be much smaller then?

Kobayashi-Solomon: Yes, it does, but usually the years when volatility falls, it doesn't fall by as much as the years when volatility really rises.

Stipp: So, let's talk about some specific investment strategy. So, if we're seeing volatility narrowing a bit because of hopes about stimulus, continued stimulus coming out, what kinds of investments might you think about as an option investor, and also considering that we saw volatility come in pretty quickly, we could also see it widen out pretty quickly. What do you do in an environment like that?

Kobayashi-Solomon: So, there is a classic kind of options trade called a strangle that I think is pretty attractive right now. What this means is, buying out of the money calls and out of the money puts; in other words, calls and puts that are struck away from the market price of the S&P 500. So no matter if the market goes up a lot quickly, or if it goes down a lot quickly, you still are exposed to a profit in that case.

Stipp: So, this is basically saying, I don't know if we're going to have a big upswing or a big downswing, but I do expect that we're going to see a lot of volatility in the meantime.

Kobayashi-Solomon: Yes, exactly. So, this is my favorite phrase, heads if you win, tails if you win. This is another one of those.

Stipp: With those headlines that we're still seeing, one thing that we are fairly certain about is that there's going to continue to be a lot of volatility in the market as news comes out, as policy decisions are made, and they try to implement them, and all the uncertainty that comes with that.

Well, thanks for joining me Erik with the analysis on recent volatility and also the individual investment idea.

Kobayashi-Solomon: My pleasure.

Stipp: From Morningstar, I'm Jason Stipp. Thanks for watching.

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