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Brown Monday


The crash in volatility began Monday and continued through the week. Option prices have eroded dramatically as a result, driving the popular VIX index to recent lows. The fantastically cheap option prices mean a lot to a geek like me and I have been busy building my portfolio. Doing math all day without a break can be tiring, but hopefully worth it.

First of all, why do option prices (implying future volatility) drop into rising markets even when markets are more volatile as they rally? The reasons are purely technical, which is why there is opportunity.

In the last 20 days the Dow has rallied approximately 600 points or 6%. This translates into a 6% x SQRT (225/20) = 20% actual volatility. That actual volatility is much higher than previous to the rally, so why are option prices falling?

The new darling mutual funds are funds that sell options to "earn" income. The strategy is not stupid, but the way it is employed is. Selling expensive options has a good return for risk profile; selling cheap ones does not. These funds tend to be fairly indiscriminate about this (they have to put money, other peoples' money, to work don't they). Their primary analysis is, "the stock is up so let me sell a call because the probability that it won't go through the strike is pretty good." This is a little unfair of me, but not much. They do use some return math (if I sell this call at this price I can earn this much return if the stock is at the strike at expiration), but that math does not account for risk, the risk of the stock going down (they should use volatility analysis for this).

So when stocks rally they get out their guns and start selling calls. With an estimated new $10 billion of these types of funds over the last year this firepower has increased dramatically, hence the magnitude of the drop in option prices when stocks rally.

In building a portfolio I must try to gauge how much this selling will drive option prices down. I am never right so I experience losses (we are down 70 basis points so far this month) when building. When I feel like I am positioned right I then wait for volatility to pick back up. Sometimes I have to wait for a while, which again can produce losses. This is the risk I take.

The last time index implied volatility dropped from 14% to 10% while realized volatility actually rose was the rally that began in early November 2004. In two different cycles I did not have to wait very long for volatility to pick up as the market subsequently dropped almost 5%, rallied 5%, and then dropped 6%. Each time the market dropped implied volatilities increased before the rally. So in the last several months there has been a distinct negative correlation between market direction and implied volatility.

If the market continues this behavior and the market falls from here with option prices currently cheap, I will be looking to see if volatility picks up as it goes down. If it does not I will tend to stay long it; if it does I will sell some of what I have been buying out.
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No positions in stocks mentioned.

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