Condor Options'  Instablog

Volatility Tracker for the week of November 8, 2009

I wondered last week whether we would see a return to the reflation rally or were entering a new regime dominated by mean reversion. The price action last week counts in favor of both, as we reverted to the closing highs of the prior week; I expect a more definitive answer by November options expiration.

The sale of out of the money equity index puts and/or put spreads I suggested last week worked out nicely, as prices moved higher and most of the equity implied volatility indexes printed five consecutive lower closes. For example, the SPX November 1020/1015 put vertical closed Monday at a $1.55 credit, and could have been closed Friday for a debit of about $0.35, a 34% return on capital risked. Our newsletter subscribers and managed accounts were positioned similarly.

The 30-day historical volatility of oil (USO) made new lows for the year, closing Friday at 27.24. [16] The last time this short-term measure of oil volatility was this low was in May 2008 amidst a strong up-trend. In contrast, recent price action has been relatively trendless; the spike to 1.6 in the implied/realized ratio this week suggests that any option buyers have seen considerably less volatility than they paid for a month ago. I would consider net buying options with crude below the $76 level.

Volatility Tracker for the week of November 1, 2009

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One average of the volume of contracts traded in VIX futures recently exceeded the level observed during the financial crisis of 2008, indicating that sophisticated traders and investors may be preparing for an end to the recent run-up in equity prices. The chart below shows the volume of trading in VIX futures (VX) since January 2008, along with a 20-day simple moving average of that volume; as evident there, the average volume in recent weeks is greater than at any time in the past two years. Increased VIX futures trading volumes are to be expected amidst market declines, given the increased activity observed in late November 2007 and October 2008; what is remarkable about the recent surge in volume is that it has coincided with a bull market in which declines are brief and mild.

According to data supplied by the CBOE, the average daily volume traded in VIX futures for October 2009 has been just shy of 7000 contracts. The average for October 2008 was about 5200 contracts, or just above 6000 if we include the 25,000 contracts traded on September 29. The contract size of (and limited access to) VIX futures has kept them from being widely adopted among retail and individual traders, so it seems fair to suppose that activity in this product represents the opinions of “smart money” traders, or is at least not merely the result of this product becoming more popular.

However, it is worth considering who exactly is likely to be taking positions in VIX futures: derivatives desks with short volatility exposure in other assets, liquidity providers hedging VIX options sold to small traders (see the chart below), and large equity funds looking for portfolio insurance are all possible candidates. Increased trading by those sorts of actors can just as easily be interpreted as neutral or guardedly bullish, instead of ominous.

As the S&P 500 tests its 50-day moving average for the fourth time since March, it will be interesting to see how trading in the VIX complex responds to any sustained weakness in equity prices. The presence of traders making bets on increasing implied volatility is not, by itself, of particular interest – but it should be informative to see how those traders respond in the event that long volatility positions begin to play out favorably.

Volatility Tracker for the week of October 26, 2009

As I’ve noted on many occasions here, the relationship between spot VIX and longer-dated VIX estimates has not “worked” as a directional indicator for at least several months. [7,8] This looks like a genuine puzzle: the premium VIX futures traders are willing to pay and/or requiring in order to sell is too steep and has been too persistent to be dismissed as a phenomenon typical of the “wall of worry” that bull markets proverbially climb. But neither is that premium indicative of some impending crisis -at least, it wasn’t this summer and hasn’t been this fall. It is tempting to suppose that the effects of artificial government liquidity are overwhelming whatever information this relationship would otherwise provide. But whatever the cause, I won’t regard the VIX term structure data as meaningful until there is some new reason to do so.

RVX futures haven’t updated for a few weeks now; if there isn’t any volume next week, I will drop that chart from the report.[7]

Options on gold have been relatively expensive lately -even with the news-making price moves, option buyers haven’t received much of a realized volatility bang for their implied volatility buck. Ratio trades involving net sales of out of the money calls are one way to play the realized/implied imbalance as well as the vertical volatility skew. [12,13]

Options on USO, the crude oil ETF, have been fairly priced in recent weeks in implied volatility terms. [16, 17]

Volatility Tracker for the week of October 19, 2009

The time to write "the fear is gone" stories will be with a VIX at twelve, not twenty-two. A story in the financial press on Friday featured a few quotes from traders claiming that a lower VIX means that equity holders aren't as fearful as they used to be. While that observation is true, it's also rather banal. Levels of human fear and concern are squishy, qualitative factors; every quantified implied volatility index, on the other hand, still registers expectations that, years ago, would have been regarded as warnings. The Implied Daily Move table (below) shows in price and percentage terms the movement that current option prices across several asset classes imply for 68% of trading days. For example, if the current VIX reading is to be believed, we can fairly expect to see moves of 1.35% or more in the S&P 500 two out of every three days. But we're clearly not seeing that kind of price behavior, and haven't for some time. Both the excessive implied daily move and the upward-sloping VIX futures term structure [7] don't necessarily entail that options are currently overpriced, but they do suggest that there is a persistent bid in volatility that is not dissipating. In international relations, states use "confidence-building measures" to reduce fear and build trust in other parties, often by sharing information or conducting joint military exercises. The federal government have been engaged in their own project of confidence-building for over a year now and, if anything, the persistent volatility premium recorded in these indexes looks like a sign that confidence has not yet been restored.

Volatility Tracker for the week of October 12, 2009

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