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Buzz and Banter

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VIX is scaping along its multi-year lows and there seems to no end in sight based on the market action. Even though VIX is up slightly today, this is due to some put buying in a few of the sub indexes. In individual equity options, I see nothing but option sellers. As the selling continues in individual equity options, it begins to spill over into index option pricing. As I have described, in my mind there are three basic phases to the supply for options that generates an overall decline in market volatility.

The first phase involves over-writers, those investors that are long stock, comfortable with holding it, but selling out of the money options to generate income (a subset of this activity is put selling in lieu of stock buying). Some would say this is hedging activity that as a contrary indicator, means that there is more buying ahead. I have already stated that I look at it differently. Over-writing only hedges the downside for the amount of premium, probably 1-2%; then these participants are just long stock. It also does not foster short covering: when prices rise they either roll their options (although this creates some demand) or just let the stock get called away.

The second phase of option selling involves volatility hedge funds and market makers, who seeing the supply of options and who begin to lose money being long options (volatility), begin to sell out their long gamma. This phase is somewhat like capitulation and leaves the market vulnerable as these leveraged players have no long gamma in place.

The third phase is when the levered hedge funds and market makers sell volatility to open to make money. This leaves the market very levered and was the situation in 1987.

My best guess is that we are at the end of the second phase and beginning the third.

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No positions in stocks mentioned.

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