Mr. VIX and Sweet 16

by Tyler Craig | July 5, 2012 9:46 am

Like a balloon being deflated, volatility expectations have seeped out of the market at a fairly rapid pace. While the S&P 500 Index is up a cool 5% since last Monday, the CBOE Volatility Index is down 23%.

So, what might we attribute the recent implied volatility swoon to? Well, it’s likely a combination of the following factors:

1. Seasonality

While many pundits like to harp about seasonal patterns in stock prices, the VIX has also developed some pretty consistent behavioral quirks at certain times of the year. Take the summer, for instance. The stock market doesn’t exactly have a history of high volatility during the summer months. This expectation works its way into option prices, leading to lower VIX levels.

Fellow option writer Adam Warner ran the numbers on the average VIX levels from 1990-2007 in his book Options Volatility Trading and concluded that the July expiration cycle produces the lowest average VIX reading at 17.31. While things may have changed a bit since 2007, the tendency for lower volatility in the summer remains in force.

Bottom line: Absent any type of exogenous event that ramps up market volatility, expect a sleepy VIX in July.        

2. Running of the Bulls

Let’s not forget the simple truth that the VIX has a strong inverse correlation to the S&P 500 Index. Given the sharp bullish turn of events that has transpired over the past week, is it not logical that the VIX would drop? Since midday last Thursday, the market has been on a tear as participants shed their fear and angst in exchange for hope and optimism.

One could also make the case that the outcome of last week’s euro summit brought short-term clarity to the markets and thus resulted in a swift drop in the amount of “fear premium” built into option prices.

So what should we make of the VIX entering the sweet-16 level? Are options now a bargain buy, or do option sellers still hold the upper hand?

Compared to recent realized volatility in the market, a VIX of 16% certainly appears somewhat cheap. Twenty-one day historical volatility on the SPX sits at 18%, while 10-day historical volatility is at 21%. In other words, if the next 30 days play out in similar fashion to the past 30 days, current option premiums will end up being a great buy.

But, of course, past is not always prologue. If the market is entering bull mode, the next month should bring much less realized volatility than the recent market correction provided.

Craig VIX 300x158 Mr. VIX and Sweet 16
Click to Enlarge
Bottom line:
Short volatility plays really don’t look that great here. But that’s not to say they won’t become appealing if actual realized volatility comes in. Short volatility strategies can be lucrative even with a VIX at 16 or 15, provided realized volatility in the market ends up being much lower. 2003 to 2007 provides a good example of such a market.

At the time of this writing Tyler Craig had no positions on VIX related products.

Source URL: http://investorplace.com/2012/07/mr-vix-and-sweet-16/
Short URL: http://invstplc.com/1fqEADu