Where to From Here?

But for option traders, the VIX has less appeal as a market predictor than a broad measure of whether options are relatively expensive or cheap, and whether it makes sense to pursue long- or short-premium strategies.

The vega of a position -- that is, the change in value of option resulting from a change in implied volatility -- can often be the difference between a profit or loss, and is sometimes more important than being right about a directional move.

While it's always nice to have the wind of time-decay (that comes with being short premium) at your back, yesterday’s move was a reminder of the quick pain that can be delivered.

The Healing Process

During the height of the credit crisis, many market commentators turned to medical analogies to explain what was happening. The situation was often compared to a heart attack, where blood (money) had stopped flowing. By January, it was deemed that the heart was back to pumping, but only feebly; the patient was said to remain in intensive care, still in need of frequent liquidity injections.

The metaphor continues: Even though it will take time and the patient won't be engaging in the high-stress, risky activities he once enjoyed, a full recovery is predicted.

What happened in the option market and the explosion in implied volatility was less a vascular problem than an orthopedic one. When the market suffered a bone-crushing “break," there was associated swelling.

And the broken area is still very tender. Any new bump to the injured area can cause renewed inflammation. The patient (investor) with the memory of the intense pain will flinch, and move to protect himself by purchasing options. I suspect it's this type of behavior that will keep volatility at lofty levels.

While the VIX is still at relatively high levels on a historical basis, I think it fairly reflects the volatility and risk of the current market environment. Over time, it will likely revert back to the historically normal range of the low 20s. But for the next few months, it's likely to stay at inflated levels.