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Volatility Could Still Drip Lower

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How low can you go?

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Stock indices are poised to open higher this morning, again, as traders show little concern that today's Federal Open Market Committee meeting will result in any change -- not only in rates, but any language associated with inflation risks or a reset of the timetable for keeping rates low. We have yet to see any meaningful selling pressure and there's no indication that it will emerge today.

That line of thinking and lack of worry is becoming evident in the dripping away of option premiums as implied volatility measured by the VIX is now down to the 22% level -- its lowest in more than a year and below pre-Lehman collapse levels.

But this doesn't mean index options are cheap; the realized or 20-day historical volatility of the S&P 500, which the VIX is based on, is sitting around 15% -- meaning the VIX is trading at an eight percentage point, or nearly 45%, premium to the actual volatility of the underlying market.

One of the reasons that implied volatility remains relatively high could be the seasonality in which investors are conditioned to be prepared for large, usually downward price swings in the September-October period. That hasn't exactly played out yet.

I supposed one could argue that it's highly doubtful that the market will simply plateau at current levels, but the market could continue to trend higher, causing the volatility to continue to drift lower.

The fact that the economy is coming out, or may still be in the midst, of the worst financial crisis in decades also doesn't fully explain the relatively high implied volatility readings among the index products or even their futures. Yes, investors may say that having been burned, they're now cautious, but that doesn't jibe with the actual behavior.

It was only a few months ago that every news item and data point could set off a string of 3% price moves and reversals across a host of markets. In recent weeks, almost everything from housing numbers to the employment picture has taken in a positive stride.

Market Full of Stocks

Another reason for the index options to award healthy premiums is the impending earnings season. But that doesn't explain why implied volatility for individual stocks, even those set to report earnings, have moved to historically low levels.

For example, Research in Motion (RIMM) is slated to report earnings tomorrow, and it's notorious for having large gap moves. Yet its implied volatility is around 55%, which, while a healthy premium is closer to the 29% HV, is still the lowest pre-earnings level in more than three years. Research in Motion's prior two quarter reports were met with option volatility in the mid-80s, and even that underpriced the ensuing moves.

According to McMillan Research, 65% of of 3,000 optionable stocks have options with implied volatilities rank within 10% of their 52-week low. Now this might not be entirely unexpected given the high levels we've come from, but the levels are also low on a historical absolute basis.

For example, in Goldman Sachs (GS), the 30-day historical volatility and implied volatility are 24% and 33%, respectively. These aren't only 52-week lows, but also near the low end of the five-year ranges.

Theoretically, implied volatility for indices should be relatively lower than the individual stocks that comprise the index because individual price moves can cancel each other out. And in absolute numerical terms, that is indeed the case. But we currently have a situation in which the index products are placing a much higher premium relative to the real volatilities of the underlying components.

Like much else in this market, it leaves one scratching their head.

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No positions in stocks mentioned.

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