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Why Individual Stock Options Got Expensive When the VIX Fell


Possible reasons for this unprecedented event.

As I noted last week, index volatility shot up way faster than individual stock volatility, implicitly a bet on increased correlation going forward. The correlation I refer to here is individual stocks moving in lockstep with each other.

Don Fishback quantifies what we observed somewhat anecdotally (and in chart form over on his site).

...There are several indexes that track the implied volatility of index options. The most widely known is VIX, which measures the implied volatility of the S&P 500 stock index options.

But what about an index that tells us the implied volatility of the options on the stocks that make up the individual constituent securities? For that, there is no index. Fortunately, I have a pretty extensive option database that allows us to make that calculation every evening. We call this SPXIV.

(To calculate SPXIV, we follow this process: 1. We calculate the implied volatility of the at-the-money front-month and next-month put and call options for each security in the index. 2. We use those results to create a rolling 30-day average implied volatility for each underlying. 3. Finally, we add up each underlying's average implied volatility and divide that sum by 500.)

...Two unusual things have happened the last two weeks. First, the market cracked and you got the normal rise in index option volatility as evidenced by the rise in the thin line. But what you didn't get was a corresponding rise in individual stock option volatility. While it's normal for stock option volatility to not rise as much as index option volatility in a market drop like we saw two weeks ago, the miniscule rise in SPXIV compared to VIX was even smaller than normal.

Exactly. Now one explanation could be that individual stock options were relatively overpriced ahead of the VIX storm. But that was not the case, both were overpriced early this month compared to realized volatility. But we've since receded. At least in VIXland. I'll let Don continue.

Since the speed of the decline in the market slowed down last week, VIX dropped quite a bit. Index options got relatively cheaper. That happens. Sometimes the additional decline in the market causes VIX to rise; other times VIX falls because the market's decline de-accelerates. In this case, the latter occurred.

What was unprecedented is what happened to individual stock option volatility. During this same time frame, individual stock options actually got more expensive! That is not normal! Folks, a rise SPXIV during a period in which VIX drops by that magnitude has never happened, at least in our 10+ year database.

Well, it begs for interpretation, but unfortunately that's impossible because as Don notes, this is unprecedented. My best thought is that the VIX rise during the week of January 19-22 was so relatively extreme, that the individual stocks simply caught up. If you told me the VIX popped 50% in a couple days I would have just assumed either the market had crashed or there was some huge anticipation of a game-changing event on the horizon. But stocks themselves didn't actually crash, and the anticipated "news" was not that cosmic (modest Bernanke uncertainty and the 850th alarmist warning from Stratfor in the last decade).

So my total guess is that Don's very real observation is a quirk of the unique circumstances that immediately preceded them.

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No positions in stocks mentioned.
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