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Skew This Volatility Index

SPX puts expensive? No, the calls are dirt cheap


The CBOE Volatility Index (CBOE: VIX) sits with a 15 full, very near the three-year lows established last week. Sounds complacent, right? Well, as we noted last week, that’s nothing compared to realized volatility, which recently hit about a six on the 10-day HV reading.

That’s the S&P 500 Index Options (CBOE: SPX) itself though, and looking backwards. Options anticipate future volatility, hence the disparity.

And a look through a different lens, shows some real Fear in this VIX 15 world. In an article Tuesday targeting options trading investors comes this from Brendan Conway in the Wall Street Journal.

“But the prices investors pay for three-month bearish put options on the S&P 500 versus bullish call options to buy the index is the most imbalanced it has been since since July 2007, a Jefferies & Co. analysis showed. That is because more traders are buying the put options.

“In another example, the “curve” of futures contracts on stock-market volatility suggests that traders question the stock market’s bullish trend several months out. VIX futures expiring in November fetch a 50% premium to today’s volatility gauge.”

Let’s look at these two pieces individually.

In the first part, Jefferies measures Skew by comparing the Implied Volatility of a put option with three-months duration and a strike price 90% of the SPX versus a call option with three-months duration and a strike 110% of SPX. By this metric, they last found a relationship this “skewed” in July 2007. So yes, that’s over-demand for put protection. But given that overall implied volatility is so low, it makes more sense to read it as under-demand for calls. In other words, the puts are closer to “normal” volatility levels and it’s the dirt-cheap calls that throw this measure out of whack.

Not sure I would read all that much into this in the context of a low volatility world. The market has plodded higher and protection does not cost an arm and a leg, so why not hedge with some cheap dollar puts? Of course someone noticing this skew in July 2007 probably thought the same thing, and the market peaked a few months later.

In the second part, he notes the steep VIX futures curve. Again, the cheap VIX itself messes with this number. Traders naturally worry more about volatility expansion “tomorrow” than they do today. I prefer looking at VIX futures premiums in absolute numbers than in percentages for this very reason. Still though, we should not ignore an $8 premium out half a year. However, in the relatively brief history, it’s more likely to see VIX futures drift towards VIX cash over time than it is to see VIX cash jump up to meet VIX futures.

We can also compare these November VIX futures to the realized volatility of SPX itself. And with 10-day HV in SPX hovering more or less around 10 lately, the volatility of SPX would have to lift about 13 points to justify the prices paid out to November. It could happen of course (see 2008), but its pretty far away right now.

Follow Adam Warner on Twitter @agwarner.

Article printed from InvestorPlace Media,

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