A Super Cheap Way To Trade Volatility With Options

| August 23, 2017 | 0 Comments

volatilityIt’s almost hard to believe, but higher market volatility has persisted for over a week.  We haven’t had more than a day or two of elevated volatility in essentially over a year.  Most of the volatility spikes of the last year or so were so short-lived, you almost didn’t know they occurred.

Even last week, it seemed like the VIX and other volatility metrics would revert to their normal low levels quickly, once the North Korea nuclear scare died down.  However, as you can see from the chart, the VIX has managed to hold onto to (relatively) higher levels.

VIXI’ve been saying, albeit without a ton of conviction, that the various issues at the White House could spill over into the markets.  And, it finally appears to be the case.  The current administration is in such a state of disarray, that even stalwart investors are beginning to fidget.

The most obvious way to see the level of uncertainty rising is through the VIX.  I’ve also been writing about gold lately, another popular safe-haven investment.  For now, let’s discuss yet another traditional investment for those worried about uncertainty:  utilities.

Utilities are interesting stocks in that they don’t always behave like a standard safe-haven investment.  They tend to still go up when all stocks are bullish.  And, they may go down when the stock market is bearish.  In other words, they don’t always serve as a proper hedge against volatility.

Generally speaking, utilities work best when there isn’t a full selloff in stocks underway, but investors are beginning to worry about a correction.  In this case, you’re likely to see rotation out of growth areas like technology or consumer discretionary and into safer sectors such as utilities and financials.

Here’s the thing…

At least one sizable trader could be betting on the utilities sector climbing to new highs in the coming month.  Given the timing of the trade – during the most volatile week we’ve seen in a year – it certainly seems like this is a bet on investors moving to utilities as a safe-haven investment.

Utilities Sector SPDR ETFThe trade itself occurred in Utilities Sector SPDR ETF (NYSE: XLU), an extremely popular ETF for utilities.  The trader purchased 50,000 of the September 15th XLU $57 calls for $0.05, with the stock trading at $54.50.  That’s $250,000 in premium with a breakeven point of $57.05.

Several more thousands of this call traded the day of this big block trade, and at least a chunk of them were likely by the same trader.  All told something like 80,000 of these calls were purchased.

Generally, cheap out-the-money calls like this are used more like lottery tickets.  You pay almost nothing and hope for a jackpot.  However, because XLU is such a low volatility ETF, these calls are less than 5% higher than the current price.

Still, you’d think if you really wanted to bet on higher utilities, you’d go at least a little closer to the at-the-money price, especially with just a month until expiration.  After all, the September 15th 56 calls are only $0.17.  They’re still very cheap and a full dollar closer to the stock price.

My guess is that these calls are being purchased as some kind of hedge against a market correction or major sector rotation rather than as a speculative bet.  Someone with a good amount of resources has determined that utilities are perhaps the cheapest way to hedge the coming market uncertainty.

Of course, that’s just a theory.  But in my experience, smart money doesn’t buy tens of thousands of $0.05 options for speculative purposes.  This trade simply makes far more sense as a hedge.

If you like the idea of using XLU as a hedge, there’s no need to buy the 57 strike.  The 56 strike I mentioned is only $0.17.  The 55 strike is only $0.46.  Since you likely aren’t going to be purchasing 50,000 options, these strikes will do just fine and are still priced quite reasonably.

 

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Category: Options Volatility Watch

About the Author (Author Profile)

Jay Soloff is an options analyst with Investors Alley.

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