Reining Instability – Options Strategies for Volatile Times 

IBKR’s Andrew Wilkinson and Steven Levine speak with Gareth Ryan, founder and managing director of IUR Capital, about how equity investors can navigate through the mounting uncertainties driving today’s markets – from rising inflation to rising interest rates, and from health crises to geopolitical upheaval. We explore the meaning of market volatility, as well as different exchange-traded options strategies to help better weather stock portfolio turbulence.   

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Summary – Traders’ Insight Radio Ep. 10: Reining Instability – Options Strategies for Volatile Times

The following is a summary of a live audio recording and may contain errors in spelling or grammar.  Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Hello and welcome to IBKR Traders’ Insight Radio podcast. I’m Andrew Wilkinson, director of trading education at Interactive Brokers, and I’m here with my colleague Steven Levine, senior market analyst. Welcome Steve. 

Steven Levine 

Welcome, thank you so much. 

Andrew Wilkinson 

And we’ll be hosting today’s program where we’ll be talking with Gareth Ryan, founder and Managing Director of IUR Capital, about the options market and the recent bouts of volatility we’ve been experiencing. Welcome, Gareth, how are you? 

Gareth Ryan 

Indeed, yes thank you for having me having me along, Andrew and Steven. 

Andrew Wilkinson 

You’re very welcome. Can you tell us a little bit about IUR Capital and your background and just kind of frame the program for us today? 

Gareth Ryan 

Yes, so I set up IUR Capital 15 years ago this year. We are an investment advisor focusing on the use of exchange-traded options strategies in a portfolio. 

Andrew Wilkinson 

Very good. Well, we’re very happy you could join us Gareth. And we’re going to be talking all about volatility, the concept of volatility, what it is, and how investors use it. So, it seems, so far, with 2022 kicking off – we just got the first month of the year behind us – it’s a rocky year so far, and there appears to be a long list of catalysts that are driving this: whether it’s inflationary pressure and tightening of monetary policy by the Fed, the ongoing health crisis with COVID and its variants, [and] geopolitical tensions among them as potential catalysts. It seems against that backdrop traders with long option positions may still be relying on the buy the dip mentality. 

Recently you gave us a great webinar presentation for our listeners, and it was called Volatility Strategies for a Volatile Market, where you explored a range of related topics. And we wanted to get started by getting your insights into volatility. In your view, what is it? Is it a bad thing for the financial markets, for traders and for investors? And, I guess generally, if you can tell us a bit more about how option-based strategies work in a stock portfolio. 

Gareth Ryan 

So yes, that’s a good question to start off Andrew. As investors, we need to understand that there are two types of volatility. We have realized volatility, also known as historical volatility, and we have implied volatility. Anyone with an equity portfolio will understand, or should understand at least, what realized volatility is: how volatile has the market been recently? Then we have the implied volatility, and for any investor out there that’s using options, they need to understand what implied volatility is telling us.

When we look at the options market, what we’re really talking about is volatility. High implied volatility means high option pricing, low volatility means low option pricing. And we need to understand that when we look at volatility in a stock portfolio, we have to factor in both the realized volatility, and if we’re using options, the implied volatility, because both of those factors are driving what’s happening within a stock portfolio for an investor. 

Steven Levine 

Is there correlation between those two? Does implied volatility have any effect on realized volatility? 

Gareth Ryan 

Well, in certain market conditions we have correlation that means that the implied volatility will either be above or below realized volatility. We need to think about realized volatility as in as I mentioned, what’s happened in the past, but for anyone in options, what’s more important is actually the implied volatility because, as I mentioned, that high implied volatility as an option buyer means that option pricing will be higher than in a low volatility environment. And today we’re going to talk a little bit more about what’s been happening recently with both realized volatility and implied volatility and what is our outlook essentially for those two types of volatility in 2022.

Andrew Wilkinson 

So, for simple long only portfolio holders, potentially new investors holding stocks. What opportunities could they therefore be missing? 

Gareth Ryan 

So, anyone that’s holding a long equity portfolio as I’ve mentioned, it’s been an interesting start to the year, but we’re not really of the belief that as January goes, so goes the market for the rest of the year. 

There will be challenges that we’re going to talk about today on this podcast regarding 2022 on our outlook for equity market generally. But when we look at these equity portfolios that perhaps have solved portfolio volatility increase in the past few weeks, we like to think of this as the opportunistic approach whereby it’s been the first time in almost two years that we’ve had a correction. That is, of course a 10% decline from the all-time highs, and that’s exactly what we’ve got for equity indexes in January of 2022.

In terms of opportunities, there would be an opportunity in a 10% decline to look at adding some names to the portfolio for that long equity portfolio at a discount, or at least at lower levels, but then of course we also have to think about the options side. Given the fact that the implied volatilities have increased significantly in the first few weeks of the year, that’s an opportunity for both option buyers and option sellers. And once again I’ll remind everyone that the high implied volatility that we’ve had in the past few weeks, you can capture what we call a volatility premium. 

The volatility premium means that as a seller of option premium, you are essentially receiving a higher credit to take the risk of holding that short option position. We’ll talk a bit more about that and strategies as well in the upcoming points. 

Steven Levine 

I recall from your webinar presentation you asked the audience whether they thought that the VIX would track above 40. I thought that this was very interesting. I know we’ve recently tracked above 30. First, can you please put that number in perspective. What are its implications if it does get above 40?

Gareth Ryan 

So, let’s remind everyone what the VIX is telling us first and foremost, okay, particularly for the retail investor that may have saw and heard about the VIX, but doesn’t truly understand its implications and what we can gauge from the VIX. The VIX is essentially the volatility index for the S&P 500 Index options — more specifically, the 30-day implied volatility of S&P 500 Index options. Now, when we look at it as a metric of risk for the S&P 500, anyone looking at the VIX chart going back 10-15 years will see that we’re actually trading—Today we’re trading relatively close to the long-term historical average, which is. 

between the low-and-mid 20s for the volatility index. Now, last year – 2021 – the VIX was somewhat preoccupied below 20. If we look at the number of days in 2021 where the VIX was trading in the mid-to-low teens, you will see that there were many more of those days than where the volatility index was trading above, or significantly above, that longer term historical average.

When we have a VIX at a 40 handle, as we talked about on our recent webinar, that implies higher volatility, or that we’re expecting higher implied volatility for the S&P 500 Index. And of course, that’s exactly what panned out during January of this year. But I’ll also mention one important thing, when we have a 40 VIX we also need to look at, particularly once again the retail investor: How long do we spend at 40 on the volatility index, as in how many days is the market trading in a 40 VIX? And the answer quite simply, is not a lot. On that recent webcast, we also spoke about the fact that we always see this near-term immediate retracement when we see that spike in the volatility index. And that of course tells us that at the same time, the S&P 500 index is bottoming out, it’s forming a near term bottom formation. That of course is exactly what happened during the final few days of January, and we also need to remind ourselves of the inverse correlation between the S&P and the VIX. That means that when the VIX is rallying, or we see a spike in the VIX, the S&P 500 Index is typically selling off quite sharply, and of course you can draw a chart and you can take a look at that price action during a January market action. 

Steven Levine 

Is that proportional? So, if it’s in the mid-teens and it goes to 40 or say it’s at 20 and it goes to 40, do we see that inverse relationship at the same magnitude?

Gareth Ryan 

Yes, so typically the volatility index will move inversely to the S&P 500 Index about 75-80% of the time. So, it’s not entirely … it’s not 100% inverse in terms of its action. There are other factors involved with daily moves on the VIX, but when we have a move from 20 to a 40 handle on the VIX, that implies that there is a sizable decline going on with the S&P 500 Index. In the case of January’s price action, we had about a 13% decline, so we entered correction territory, and I believe the lows from the January volatility— we were about 13% off the highs. 

Steven Levine 

So, what would an options investor do if the VIX were to reach 40 or higher?

Gareth Ryan 

So, when we have a 40 VIX, the question we have to ask ourselves is: Is there more upside for volatility? 

That means, inversely, is there going to be more downside for the S&P 500 Index? As I mentioned, we had a 13% decline. We were not looking for a bear market. We have other factors going on, of course in the world, not just the fact that interest rates, or the regime for interest rates, is changing in 2022, but there are other factors we have to consider.

So, as I mentioned, we bottomed out at a 13% decline for the S&P. If we have a 40 VIX, as I’ve mentioned in the past few moments, the retracement that we had took place very quickly. Within a matter of days, we had retested the 30-handle. So, for investors the question is: If we have a 40 VIX, are we willing to look for more upside, or are we looking at a bottom formation on the S&P, and, if so, that means that the VIX is topping out near term. And in that case, we would look at downside action on the volatility index with our option strategies. 

Andrew Wilkinson 

Gareth, I’ve got a I’ve got a question for you. We talk about the whites of their eyes. What’s the conversation go like with a client when faced with a couple of days of headlines are about stocks crashing around the world? Markets down ‘X’ percent, fears of rising interest rates and you’re sitting there telling the guy this is what you should do. I want you to buy something or we’re going to sell some volatility. How does that conversation go? 

Gareth Ryan 

Yes, so with retail investors or there is an unfortunate common theme in that is that they are selling or liquidating positions at or near the bottom and once again, unfortunately, we saw that pan out with retail investors, not just our own clients, but with retail investors in general, during the January market sell off. The most important point to make is that, particularly if you’re long-term with your view, January market decline was significantly less than the March 2020 market meltdown. In fact, it was about a 30% sell off relative to the size of the declines during March of 2020. That was a very quick and fast bear market coming on two years ago now. The January price action was more realistic in terms of its reaction to a change as I’ve mentioned in the interest rate environment. And it’s also important to bear in mind that the bottom that we saw in the S&P in January was around, or at, leading up to the Fed meeting, which of course is really where the catalyst for all this has come from.

And in fact, the price action was also similar to that of December’s market declines before the December Fed meeting but going back to the question about retail investors. Yes, you know, we’d like to think that retail investors are opportunistic by nature, but unfortunately with some investors out there, yes, they tried to manage their risk by limiting their drawdown at or near the bottom of the declines in January. 

Others, however, were sitting with high levels of cash, and we’d like to think that they were able to take advantage of that. As I’ve mentioned, there were some names that started the year down more than 20%. Some of those names were also the best performers of 2021. They have recovered modestly from the recent sell off but we’re not expecting last year’s best performers to be once again, this year’s best performers. There will be other parts of the market that investors should be looking at. They need to pick and choose and then they need to be nimble about where they want to have exposure in their long equity portfolio this year. 

Andrew Wilkinson 

We frame that: the sell off, and there’s a bounce, and then you start looking at using core options to get upside exposure. But what happens is … there’s an erosion of implied volatility, which, as you mentioned, is an inherent part of an options premium. How does an investor manage that? 

Gareth Ryan 

Yeah, so there are two things in the options market. We have buyers, of course, and we have sellers. Now, when we look at selling an option premium, and this goes back to the question that we asked our audience recently: What would we do with a 40 volatility? Do we think the VIX is going to hit 40? Well, if we thought the VIX was going to hit 40, we would be an option buyer. In particular, of course, we would be a put buyer. As we know when we buy put options, any increase in the implied volatility will benefit our put option price. Of course, with call options, we are of course looking for upside in the underlying market. If we are a buyer of call options, or for that matter call spreads, both of which are bullish strategies, then we have upside bias. We will participate in any bounce in the market. 

But the one problem that we need to remind ourselves … for the retail investor out there … is that we need to be right about market direction as a call buyer, we have that market bias. Whereas with the option seller, they can align themselves to be wrong with market direction and perhaps still have the chance to retain the premium. Remember that when we talk about selling option premium, many retail investors out there are only interested in one thing and that is keeping the premium where that option expires out of the money, and we need to think about that when we have those kinds of market moves. We had, as I mentioned, a 13% decline. There are two things you can look at being a call buyer on a market sell off with the expectation that we will bounce, or we are an option seller that means we’re selling out of the money puts or put spreads with the expectation that we keep the premium, once again, but we do not necessarily need to see an immediate bounce for the underlying market. 

Steven Levine 

It’s really terrific, and I just want to circle back a bit Gareth about being more nimble this year about your selections for your long equity portfolio. Would you consider ETFs [exchange-traded funds], then, being too diversified? Or how do you consider ETFs versus single name stocks? Is there more of a risk or concentration on single stock names, or would you opt for an ETF or an ETF basket? 

Gareth Ryan 

So, we are a proponent of using index ETFs for our clients that we advise. And one of the main reasons for that is that we can essentially distribute our risk across the index when it’s an index ETF, of course, with exposure to various sectors and industries – that of course is where the S&P 500 ETF does, well, we’d like to say a great job of giving us that access to those sectors and industries. But also the Qs [Invesco QQQ], for example, or the IWM, the Russell 2000 Small Cap ETF. The small caps had a very tough January. I believe they briefly tested bear market territory during the lows of January, so of course if we’re talking about being opportunistic, that’s one place we could look at. So, those index ETFs are certainly one place that we’d like to have access to. Then below that, if we drill down, we can look at those sector ETFs, and I’ll go back to my point that we need to be nimble this year. We need to look at what areas we want to have access to. Energy, of course, we’re looking for energy to have another solid year, so we look at the energy sector ETF’s or the utilities or the financials. But then we also think about the growth names that were once again last year’s best performers. We’re not expecting that to play out again this year, so we need to think about what kind of exposure we want to have to those names. 

Single names we can also be more selective. One thing we have to think about with single name exposure is exactly that, we have exposure to that single name and the broader market on any given day … or any given short-term period may be performing relatively well, but you have exposure to a single name that has a corporate earnings, or a news story that’s coming out that may adversely impact the overall portfolio. So, be nimble, pick and choose where you want to have access to with your single names and again, I repeat, do not expect last year’s performers to be this year’s performers once again. 

Steven Levine 

And you mentioned financials … and thinking about the rise in rates, or rise in Treasury yields … thinking that XLF, for example, may be something to consider in this environment. I mean, do you see the fear playing into broader market volatility surrounding rising yields? Maybe that would be a boost for bank stocks and XLF as a basket? 

Gareth Ryan 

Well, if we look at 2021, in fact the banks had a stellar year last year. Most of the tier one banks had a return of 30 or 40% for the year. They did start out 2022 on a solid note, but of course they were also somewhat caught up in the January market volatility. We’d like to think that in the changing rate environment, banks and their lending business would benefit from a change in the rate environment, but there may be some delay to that, and there are other factors involved as well. With that being said, yes there are perhaps two or three banks that we’d like to own individually, outright. And of course, going back to our discussion on options, we can set ourselves target prices to own one or more of these banks through cash secured puts. So, we don’t necessarily need to be acquiring these bank names at current market levels. We could, for example, look to sell cash secured puts 5% out of the money, which of course lowers our target price on those on those banks.

XLF also had a good year last year as a result of the expectation that rates will be changing this year. It’s had somewhat of a mediocre start to 2022. Let’s see how that plays out at. Bear in mind that XLF the components of that are not just banks, there are other components in there to take a look at. 

Steven Levine 

Other financials are related but not necessarily banks, yeah? 

Gareth Ryan

Correct.

Andrew Wilkinson 

I’m not sure about you Gareth, but I didn’t learn much from the Fed in January, did you? 

Gareth Ryan 

Yeah, I think the Fed’s role that everyone should understand is their dual mandate. We need to think about how hawkish were they in their [Jan 26, 2022] statement. One of the things I will say actually before the Fed meeting in January. If we look back to the very first couple of days of the year, we actually started out on a solid note for equity indexes. But then what came along? Well, we had the Fed meeting minutes from that December Fed meeting, and if we look back at the price action, it seems that may have been a catalyst, because when we look at our charts, take a look at SPX or the Qs or the small caps, that is actually where we had a turning point. We had a pivot point for these indexes, and that’s when we started to come off the highs and we started to form this correction price action.

So, the actual Fed meeting itself, we have the Fed meeting minutes in a couple of weeks. It was relatively hawkish. They did repeat what we were expecting. That is that they’ll raise rates when they need to and we had a somewhat tepid reaction initially, but we did bottom out for equity indexes shortly after that Fed meeting. Let’s see what the meeting minutes come out within a couple of weeks because I’d like to highlight to everyone that it’s not just the Fed meeting itself, it’s what those meeting minutes say. And of course, that’s where we have to wait for those a couple of weeks from now.¹ 

Andrew Wilkinson 

So, Gareth I want to just pivot now to weekly options, which has been a great financial innovation. 

Can you just explain to the audience what these are – the weekly options – when they were introduced, and why do you think they’ve been so successful? 

Gareth Ryan 

So initially, folks, when we looked at the options market going back 15-20 years, we had in many cases just one traditional monthly option expiry for various products, not just index options, but for single names as well. That means that our time horizon – our minimum time horizon – as such, would be 30 days … going out 60 or 90 days, if we were taking a more long-term position. With the advent of these weekly options, which were introduced by the options exchanges, it allows us to be more selective about our time horizon and of course to manage our risk within that time horizon. 

Now, initially when weeklies were introduced several years ago by the options exchanges, there would be a Friday weekly expiry. But since then, we’ve had a further improvement, of course, and now for the retail investor in particular, we have in many cases a Monday expiry, a Wednesday expiry, and of course, that Friday option expiry. In some ways you could consider this more opportunities for the retail investor to acquire risk with a very near-term time horizon. But we also need to factor in if we’re selling options in particular, which, once again, many retail investors are focused on for premium: we need to factor the risks of selling that very near-term weekly option for premium and the fact that we will likely have more exposure to daily volatility … daily market moves. 

So, we need to balance out those two time horizons. Those very near-term weekly options and of course those longer-term traditional monthly options. There may be scenarios in certain market conditions where it may not be appropriate to be focused entirely on near-term weeklies. There may be opportunities to widen your horizon and allow your portfolio to have more volatility with those longer-term traditional monthlies. 

Andrew Wilkinson 

And it would seem to me that it’s not just the options volume on the weeklies isn’t just concentrated on the bigger names, it’s that there are other smaller names. It’s kind of now that I can do this, I’m going to do it, seems to be the mantra. 

Gareth Ryan 

Yeah, so initially the weeklies were purely for those indexed products. The liquid names were– We see a lot of volume on any given day. Now it’s expanded into these single names, which have also become very actively traded, once again through retail investors, over the past 12 to 18 months. And with that being said, you need to look the liquidity within those weekly options. Do you have enough liquidity in very near-term weekly options for single names? And if so, what is your objectives are with that time horizon? 

I would also point out that when we look at weekly options, we also need to think about the strategy we’re going to use. As for the option selling community out there, we as a firm, typically avoid option strategies which have unlimited risk. So, while we talked about cash secured puts previously, in addition to that, we are essentially focused on spread strategies, which once again provide that defined-risk, defined-return scenario. I would like to advise clients, retail investors in particular, to avoid unlimited risk option strategies. And of course, we’re talking about those uncovered options which expose your portfolio to potentially unlimited risk as an option seller. 

Andrew Wilkinson 

Also, as an advisor, you do all the monitoring and the decision making for someone’s portfolio, but. 

what could somebody who wanted to start with options do?² What should they look at and how do you know when volatility is working for you or against you?

Gareth Ryan 

So, anyone starting out with options who had that long equity portfolio example we were working with … they need to very simply understand the basics. They need to understand what calls are doing for them and what puts are doing for them. Focus on being a buyer of options at the beginning, a buyer of calls and a buyer of puts. Perhaps set up a demo or simulated trading account so you can understand what happens when you buy a call option or what happens when you buy a put option. 

Then when you start to see the price action with those, then you can look at, for example, buying spreads or buying call spreads or buying put spreads. You can do this over the time horizon that suits you. If it takes you several weeks or several months to get comfortable with dealing in options as a beginner, then then you should focus on that before committing capital, real capital to any option strategy in your portfolio. 

Once you understand what option buying involves, then you look at your long stock portfolio. 

What is the most traditional basic option strategy out there? Well, aside from long call and long put, of course, it is a covered call strategy. Selling calls against your stock essentially for a rental premium with the objective of keeping that premium. Covered calls have, I believe they were the very first option strategy that was most widely used going back more than 30 years now. That’s where you should start out, and then once you can understand covered calls and the risk return profile, then you move into the more advanced area, which is where you’re starting to sell options. That means you have a short option position. You receive a premium on the opening transaction that is a credit to your portfolio, and typically your objective is the same and that is to keep the entire premium for the portfolio. 

Steven Levine 

I would like to just go back a bit when we were talking about the Fed. And we had a call recently, and I remember in that call you mentioned the term ‘Beijing put’. I thought this was really interesting. We’ve heard the ‘Fed put’, but now it seems that the People’s Bank of China seems to be undergoing some kind of scrutiny by Beijing. It’s being more accommodative at a time when the Fed is now becoming more hawkish and removing liquidity and hiking rates, or talking about hiking rates.

So, it seems these two central banks have these diverging monetary policies. Used to be it seemed that most global central banks had a concerted monetary policy and providing liquidity or keeping things accommodative. But now these two seem to be diverging. So how does this influence, say the US markets and volatility, and is this something that options traders should watch out for? 

Gareth Ryan 

So, this actually tells us that the two stages that the US and China are at with their economies. We, as you mentioned, we’re familiar with the Fed put. Retail investors understand that the Fed has provided an unprecedented amount of stimulus to the economy, not just during the COVID era, but going back to 2008. So over that 10-to-15-year time horizon the amount of stimulus being put into the economy, that essentially props up the market because you have that Fed-induced low volatility environment. 

Now as we come out of the COVID era, we understand that rates will have to rise – They will have to raise rates several times this year, perhaps …. the Fed … to, of course, keep inflation under control. 

That’s not exactly what we see in China. It’s a different scenario. They are at a different point in their economic growth cycle, and they need to think about providing the amount of stimulus that they need to prop up their own economy. We’ve heard stories about Chinese developers and the amount of debt that they’ve accrued over the past few years, and the fact that some parts of the Chinese economy are just not going to grow at the same pace that they were growing several years ago. I would say this about the fact that this ‘Beijing put’ that we what we’ve been reading about, if it does actually pan out that they start to pump in a significant amount of stimulus, is that going to attract foreign investment? Is that going to attract foreign inflows to prop up their domestic market? The Chinese domestic indexes, they’ve also had a rough start to the year. Ok, they’re still down a few percent. To some extent, yes they do track overseas equity markets, but the amount of stimulus that they pump into the market that is going to be a major factor in how the Chinese equity indexes perform this year and to what extent they can attract foreign investment, which is equally important to the Chinese. 

Steven Levine 

I wonder if there will be a change in the magnitude in which we see those indexes. Very interesting stuff. Gareth, thank you so much for taking the time for this. Really, really enjoyed this whole podcast, whole conversation. Thank you. 

Andrew Wilkinson 

Thanks very much Gareth, and we’ll see you soon. 

Gareth Ryan 

Thank you, Andrew. Thanks Steve. 

Steven Levine 

Thank you, Gareth. 

Andrew Wilkinson 

As I mentioned earlier, you can learn more about this topic in IUR Capital’s webinar presentation, Volatility Strategies for a Volatile Market, along with other great webinars from Gareth at ibkrwebinars.com, as well as his market commentary at IBKR Traders’ Insight at tradersinsight.news. 

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1. The minutes from the Federal Reserve’s Federal Open Market Committee’s (FOMC) two-day meeting that concluded January 26 were released on February 16, which followed the recording of this podcast episode on February 1. For reference, the minutes may be accessed here: https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20220126.pdf  
2. Also, visit IBKR’s Traders’ Academy for several complimentary courses about options – available for all levels of expertise: https://tradersacademy.online/category/trading-topics/options