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Time to Short Volatility? Note: Published May 21, 2010

|Includes:SPDR S&P 500 Trust ETF (SPY), VIXX
Recent action in the markets is obviously very scary, and I am certainly among the most scared.  But I wanted to delve into the internals of the option market to see how what we're going through right now compares to the last 10-12 years or so of market action, and I found some interesting observations.

I shared the VIX Rate of Change chart a couple weeks ago after the flash crash, and it has become even more pronounced.  The VIX explosion of the past couple weeks has now equaled the explosion seen during Lehmann/AIG collapse during 2008.  This is striking, as we have not seen nearly the same drop in equity markets as was experienced during the 2008 run-up in the VIX (-35% drop on the S&P in 2008 vs. a 13.64% drop in the last couple weeks).

While the rate of change on the vix measures the volatility of volatility index, which can be a dubious feature to understand, if you boil down what is being measured, it can be put to use more effectively.  Since the VIX is calculated using the prices of out of the money put and call options on the S&P 500, with a heavy skew towards puts, the VIX is measuring the price paid for put options.  When the VIX skyrockets, it is indicating that the amount that investors/speculators are willing to pay for put options has skyrocketed.  So simply speaking, the last time investors increased the amount they were willing to pay for options increased this quickly was the reference period in 2008 when the S&P fell 35%.  Since the market has currently fallen only 13.6% from the April 26 peak to yesterday, it seems the option market has priced in a full on economic collapse much more quickly than the equity markets have indicated such a likelihood.

Possible reasons for such a discrepancy range from the obvious to the not so obvious: people are obviously very afraid, and since many equity investors made such a large amount since the March 2009 low, it makes sense that many of them are rushing to buy puts to protect gains.  However, in viewing the total amount of put options traded on a daily basis going back 3 years, and weekly basis going back 12 years provides more insight.

The daily amount of put options traded in the last 2 weeks has twice exceeded the all-time high set back in 2008.  The weekly chart shows that this last week was the most put options ever traded in the US.  To me, this indicates massive speculative put buying is also responsible for the explosion in the VIX.

If you're looking to trade this market, above is a Put/Call chart from the last 10 years.  The red dotted line is the 5 day moving average of the CBOE Equity Put/Call Ratio.  This ratio measures how many put options are traded versus call options on a daily basis.  This ratio is commonly used as a contrarian indicator, showing that when investors are most fearful and buying the most puts, the market is actually primed to rally.  The 5 day moving average of the put/call ratio has exceeded 1.00 only 4 times in the past 10 years.  Of these 4 times, the S&P has experienced rallies of an average of 17.89%, lasting a shade over 2 months each time.  This contrarian strategy produced these results with zero drawdown 3 out of 4 times, and the 1 occurrence that did experience a drawdown initially was only 5% before rebounding to a total of +14.6% including the drawdown period.  However, it is certainly worth nothing that each of these rallies occurred during an ongoing bear market, and catching the intraday lows to fully capture these gains is very difficult, but if you can buy equities during this time period and get out after a ~10% gain, it seems like a relatively safe trade.

Disclosure: Short SPX puts, Short NDX puts, Long ES futures
Stocks: SPY, VIXX