If you know the basics of trading credit spreads, you know that volatility is an important component. You WANT volatility. Volatility is your friend. Why? Because volatility is uncertainty and uncertainty drives options prices higher. The higher options prices are, the more premium we can extract from our credit spreads. However, sometimes you can get too much of a good thing.
During the market’s depths of this ongoing Corona Virus, volatility went through the roof as we all know. Falling markets send volatility higher while rising market send it lower (generally). Pre-Corona, the VIX was in a low range of 14-24ish (see chart below). For traders of credit spreads, it was tough pickings as our screens didn’t pull out many high volatility candidates. Personally, I had to lower my standards to get in the game (no laughing please). Then BAM, Implied Volatility seemed to max out on every stock in the universe. Good? Well, not really. Things were so bad for a while that bid/ask spreads were as wide as the Grand Canyon. Market makers wanted to get paid for this much volatility. For traders of credit spreads, we want tight spreads and good liquidity to be able to get out if need be.
So what we have now (at least for now) is a rising market creating better credit spread opportunities as the VIX has fallen. Not the norm but we are not in a normal environment for sure. As I’ve said, this may create a Goldilocks period for credit spread traders like myself. I don’t see the VIX falling to pre-corona levels any time soon, so perhaps we have rich soil for the rest of the year. Generally I don’t look at stocks trading below $50 as premiums tend to be very small with low priced stocks. However, this market is expanding the universe of candidates. I guess being locked in my house gives me a lot of time for research!
Stay safe and happy trading,
Joe Simmons, CFA