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It's Time to Buy Volatility

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For the first time in over four months, options, or implied volatility, is inexpensive and represents a buying opportunity.

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The VIX is calculated based on a weighted blend of options, both puts and calls, on the S&P 500 (INDEXSP:.INX) with an average 30-day duration. While the VIX is often referred to as the "fear index" (because investors are typically more concerned with downside risk and therefore lean towards buying puts to protect their portfolios), it should be noted that implied volatility is directionally agnostic.

Implied volatility merely expresses the magnitude, not the direction, of the expected move in a given time frame. So while over the past few years the VIX has confirmed its status as a fear gauge, you should note that back during the dot-com bubble, it was actually the reaching for call options to gain upside exposure that kept the VIX above 30% for most of 1999-2000.

A Recent Reversion

During the month of August, actual or realized volatility dropped precipitously as the market went into a narrow trading range, but implied volatility remained elevated as anxiety regarding a series of events loomed: Jackson Hole, the monthly jobs report, the German vote to decide on approving the ECB's ability to buy sovereign debt, and FOMC meeting options kept traders on edge and bracing for potential large price moves that might be coming.

So even as the 30-day historical volatility (or HV) sank below 10%, the VIX was running around the 16% level That was a six-point, or nearly 60%, premium. This "fear" extended out in time as the term structure of VIX futures had a steep contango. The November contracts were trading at 23 and in December, at 27. These were very large premiums not only to the cash VIX, but also between the monthly futures contracts.

Given that the futures settle into the cash contract, prices necessarily need to converge as expiration approaches, meaning this extreme skew would need to be resolved.
No positions in stocks mentioned.

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