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Options Volatility Is Non-Exceptional


The VIX is now at very "normal" levels.


Bernie Schaeffer injects some reality to the "doom and gloom" options analysis.

...before you look to buy calls on the CBOE Market Volatility Index (VIX) based on a statement that "the cost of buying insurance to guard against a possible decline in equity valuations is currently very low," consider that the 15-year moving average of the VIX is 21.50. With the VIX at 21.88 as I write, the cost of buying insurance against a possible decline in equity valuations is actually very average. Worse yet for those looking to wager that the VIX is "cheap" is the fact that the 20-day historical volatility of the S&P 500 -- a pretty decent benchmark for the VIX -- is currently at 15%. In other words, the VIX as a volatility forecast is trading well above recent market volatility levels. Perhaps there are in fact too many investors who believe they need protection?

And perhaps this perceived urgency to protect portfolios from disaster might help explain the booming business in VIX options? For example, on Dec. 4 the Chicago Board Options Exchange (CBOE) reported that options volume on the VIX hit a new one-day record: 712,315 VIX options traded on Dec. 3, which easily surpassed the previous record of 426,661 set on Sept. 16, 2008. I find two things noteworthy about this record. First, about 85% of the volume was on the call side, which would likely indicate a stampede betting on higher VIX levels. And second, Sept. 16, 2008 (the date of the previous VIX volume record) was the day after Lehman filed for bankruptcy.

The bottom line is that there are plenty of players betting on higher volatility in 2010, and that the VIX is not at all cheap compared to some very important benchmarks. In other words, the bears would like you to believe they're in the contrarian trade, but I'd suggest they're in the crowded one.

One caveat though, the VIX call volume spike was on a big spread and the customer actually sold the spread. So while it printed as calls, it was a bearish bet on the VIX.

That being said, he's right on the gist of this, in my humble opinion. Options volatility is very fair right now. Implied volatility should trade modestly above realized volatility, it commonly has a roughly four point premium. A strategy that net sells options will win more often than it loses, it's just that the losses are open-ended and tend to dwarf the one's. And if I was a behavioral finance writer, I would also point out that the pain of a loss, and our reaction to it, is not equal and opposite to our reaction to wins.

And as he notes, we're very normal in absolute terms with the a low 20's VIX. There's often a knee-jerk reaction to absolute VIX numbers, but if you forget about 2008 for a second, you'd see that we're neither here nor there right now.

There's always going to be doom and gloomers, and many make arbitrary VIX observations to justify them. But there's nothing there right now, it's a very non-exceptional time.

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