Volatility? Really?

As I’m writing this, it is the afternoon of January 6, 2016. The stock market has been in full-blown meltdown mode for the last five trading days. The S&P 500 index has dropped by about 4% in that time. The Chinese stock market is down much more after dropping 5% yesterday alone. Crude oil has dropped over 6% in that time. This is high volatility in anybody’s book.

And yet, there was one type of volatility that was curiously muted: implied volatility in the options market.

Implied volatility is the name we give to the fear reflected in options prices. The more fear there is, the more people are willing to pay for the insurance offered by options. This fear factor for the stock market as a whole is measured by the VIX, or Volatility Index. The VIX is derived from option prices. It measures the expected rate of change that is built into the prices that people are paying for the options.

The VIX is charted below along with the S&P 500 Index, the benchmark for US stocks.

From these charts we can see that VIX and the S&P generally have an inverse relationship. At the end of the day on January 6, the VIX stood at 20.59%. This was a fairly modest reading compared to the levels of 27% reached in early December on a smaller drop in the stock market and the 28% reading at the end of September on a slightly larger one.

What could this mean? This was the option market saying that it did not believe that the recent rate of change would be sustained. Options market makers were willing to sell insurance against stock price drops at rates that are only fairly modestly elevated. They would not do this if they thought there was a very high probability of a bloodbath.

Are they right? Of course there is no way to know for certain, but they have a pretty good track record.

How should we respond to this?

That depends on your outlook for the stock market. If you believe that the wheels are coming off and that the option market makers are smoking hopium, you would want to sell your stocks, if you hadn’t already. You could then take a small percentage of the cash generated and buy out-of-the-money put options on the SPY, the ETF that tracks the S&P 500, with an expiration of three months or more.

If the market then did break down severely, your puts would rocket in value. Two separate factors would drive this. As the drop in the price of SPY brought it closer to your put strike price, the puts would gain extrinsic value at an accelerating rate. Besides that effect, the drop in stock prices would cause the VIX, and all option prices, to surge. The best strategy would be to sell the puts when they reached the put strike, at which point they would have the maximum possible extrinsic value.

On the other hand, say that you believed that the option market makers were correct and the CNBC talking heads were a bunch of Chicken Littles. In that case, you could do almost the same thing, except that you would not sell your stocks. Buying those out-of-the-money puts in that case would just amount to cost-effective disaster insurance.

Either way, options could give you a way to protect yourself and/or profit from the apparent underpricing of the options.

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