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In the early ‘80s, when I was running a hedge fund from the floor of the Chicago Board of Options Exchange (CBOE), I was a market maker in OEX options. The OEX is the Standard & Poor's 100 Index. The CBOE Market Volatility Index (VIX) was born from trading options on the OEX and from our desire to more accurately price risk.
The stock market volatility index (VIX) - or "fear gauge," as it's often called - has been giving off unexpectedly low readings in 2011.
But don't be fooled. Things aren't what they seem.
Structural dynamics are currently suppressing the VIX, and are diminishing its predictive power.
If you want to trade this as a speculative investment - or even if you just want to use the VIX to better hedge your portfolio holdings - you need to understand the forces that are working on this stock market volatility index.
Let me explain ...
I Was There for the Birth of the VIX
Back during my hedge-fund days, we used Monchik-Weber machines with their built-in Black-Scholes options pricing formula to help us mathematically measure put and call-option values. The computers would provide us with the theoretical value of the options we were trading.
But it wasn't long before a gap between those theoretical values and the actual market prices drove us to find a different way to measure volatility. To calculate "implied volatility" - the estimated volatility extracted directly from bids, offers and actual prices - we looked at real-time prices as opposed to theory.
Simply put, based on actual prices for calls and puts on the OEX, we separated out implied volatility and used it as a measure of what traders were expecting to happen.
This volatility measure is the expectation of price movement over the next 30 days. The higher the reading, the more likely stocks are to move in one direction or another.
Over time, our volatility index became known as the VIX. And eventually, the VIX - not the OEX - became a measure of options-pricing volatility based on the Standard & Poor's 500 Index.
The VIX is called the "fear gauge" for a good reason: As that index rises, it's basically telling us that traders and investors are paying a greater premium to buy options, mostly because they are "paying up" to buy puts.
The Stock Market Volatility Index: What's at Work?
I'm often asked this question: If there's fear in the marketplace - and traders are buying puts and their prices are increasing, and they are selling calls and their prices are decreasing - why don't the two cancel each other out and the VIX react less dramatically?
That's a great question.
And the answer comes in two parts.
First, "selling calls" is a hedge against falling stock prices. But when you sell calls against a position you hold, you only collect the "premium" or payment that you sold the calls for. No matter how far the stock falls, your downside protection is limited to the money that you collected for selling the calls, meaning this hedge has limited value.
On the other hand, by "buying puts," you can hedge or profit from a steep-and-lengthy drop in the price of the underlying stock. Even more important, in a sell-off or outright panic, investors and traders are more inclined to buy puts as protection or as a speculative position without too much concern for the prices they have to pay. That's why volatility spikes in fearful markets.
That brings us to the current situation. I think we'd all agree that there's been an awful lot of fear in the markets of late. And yet the stock market volatility index - the VIX - has remained stubbornly below (often well below) its historical norm of about 21.
So just what's going on here?
Going by these low VIX readings, investors and traders have been shrugging off a whole host of negatives that are hanging over the stock market. Bullish investors would have us believe that stock prices are very effectively climbing the proverbial "wall of worry," meaning "the market" sees good times ahead for stocks.
That may be true. But there's also more to the story.
The Rest of the Story
Before the markets reached recent highs this past spring, investors and traders began protecting accumulated profits by selling calls against their holdings. I'm not just talking about individual investors; I'm talking about institutional players, too.
At the time, all sorts of potential market "headwinds" were grabbing headlines - everything from the twin tragedies (earthquake/tsunami and nuclear disaster) in Japan, inflationary fears and the approaching end to QE2 here in the United States, soaring oil and commodity prices, and the convulsions in the Middle East, to name just a few.
What we saw was that put buying was met head-on by even-more-robust call selling. So while the buying of protective puts should have lifted the VIX, a steady stream of call selling was offsetting what would otherwise have been generally widening premiums.
The more the markets digested the bad-news headwinds and the higher stocks edged, the less put-option prices were being bid up. What's more, as things have quickly settled, call sellers have added to the downward direction of the stock market volatility index.
But there are larger, more-important structural dynamics working to keep the VIX low.
For one thing, the so-called "reach for yield" in a very-low-interest-rate environment is causing investors - and especially institutions - to sell calls against stock holdings in order to generate income.
Demographics are playing a role, too. Baby boomers have started to retire. As boomers age, they are switching from stocks to fixed-income investments, which reduces the demand for put protection as they unwind their equity holdings.
Hedging and Speculation Strategies
The real question to ask is: So where do we go from here?
It remains to be seen whether the selling of calls for income is a statement that investors believe the market has limited upside. If so, that would mean that they're willing to trade away the small chance that there will be a substantial increase in stock prices in return for a boost in their income.
It also remains to be seen whether a low VIX means that the premium options sell for is lower, making it necessary to sell more options to garner additional income. If that's the case, the lower level of this stock market volatility index would be structural, and thus self-sustaining.
But it's also possible that a terrible danger is lurking behind these low VIX readings. And that's something you need to beware of: Just because it appears as if the markets have adjusted to all these headwinds and haven't corrected meaningfully doesn't mean that they won't.
That brings us to hedging and speculation strategies.
In terms of hedging, what I can tell you is this: The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices. In the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection ... just in case.
For traders of the VIX, holding positions for big moves is out of fashion and foolish. Until the VIX stops trading in narrow bands, traders should take smaller profits and be quicker on the trigger when their trades are in the black. They can always keep a deep out-of-the-money position in calls if they want a longer-term, investment-type play.
Although the VIX is a stock market volatility index, traders and investors need to understand that it's really no different than any other investment instrument - meaning that it, too, is vulnerable to structural changes and the dynamics of constantly moving market expectations. You should always understand what's going on with the instruments you invest in and trade ... and avoid at all costs getting blindsided by moves that you could have anticipated.
News and Related Story Links:
- Reuters:
Bulls Ready to Charge into Wall of Worry. - Money Morning News Archives:
Articles by Shah Gilani. - The Capital Wave Forecast:
Official Website. - Investopedia:
Market Maker. - Chicago Board Options Exchange:
Official Website. - Wikipedia:
The VIX. - The New York Times:
Monchik-Weber Sales Talks? - Wikipedia:
Black-Scholes. - Investopedia:
Implied Volatility. - The Chicago Sun-Times:
The Sad Retirement Outlook For Midwest Baby Boomers.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
Excellent explanation of the VIX and why it has been so low during a time when one would reasonably expect the "fear index" to be substantially higher. Thank you for the education.
Interesting analysis but what caught my eye was Monchik-Weber. I worked for them in that period and used the analytic software in an options trading system for a client that helped make them a ton of money. I wound up an options trader in the deal. Brings back memories.
Very helpful, thank you. Most people seem to think the market will continue up or sideways for now, but I am not so sure we won't see further declines and had been surprised that the VIX seemed so complacent of late.
Very well done. Thanks.
One of the reasons (probably the main reason) the VIX is giving you an inaccurate measure is that Black-Scholes is wrong. It assumes a Gaussian distribution of prices. That is just incorrect. The distribution is fractal.
I fully agree with Tom Pollan's comment. I too wish to thank you for simple but comprehensive explanation of the VIX's situation in the current economic environment.
Dear Tom, Les, Phil, Jay, Martin and Fallingman:
On behalf Shah, please allow me to thank each of you for your comments, compliments and suggestions. I know for a fact that Shah read each of them … but he's working on a special project right now and asked me to respond so that you'd have more-timely feedback.
You know, it's interesting for me to read these comments as well – especially those thanking Shah for writing a column that makes accessible a very complex topic. As the founding editor of Money Morning, I was here when Shah first joined our team. And this talent of his became clear right out of the gate. So I've been blessed with the opportunity to work with this guy for three or four years now.
As most of you no doubt know, Shah is a retired hedge-fund manager. In that role, Shah worked behind Wall Street's "velvet rope" and got to see the most-intricate of its inner workings – the good, the bad, the dark and the dirty.
Granted, there are lots of folks like that. But several things set Shah apart. First and foremost, unlike most folks who are "in the know," he's willing to share what he knows with all of us. And he doesn't just tell us what's happening, he explains what it means. And, finally, he's able to take these insights, and explain how to convert them into profit opportunities.
What's more, as terrific as that sounds, Shah's "skill set" doesn't end with this ability to decipher and explain how to profit from those "events of the day." He's also a wizard at spotting major market trends, and developing strategies that let his Money Morning readers and his "Capital Wave Strategist" subscribers (that's his paid advisory service) profit from those predictions.
I like to tell this story about Shah.
It was late one night back in November 2008, and I was still here in the office. And when I say "late," I mean that it was well after Money Morning's daily news deadline, and after the next day's issue had been put to bed (meaning it was in the e-commerce team's hands and in production). But that's also the time of day that Shah tends to like to talk – it's quiet, the days' events are spread out before us, making them easy to analyze, and we've got the time to do so. (Several of the guys – Keith Fitz-Gerald, Jack Barnes and Peter Krauth – do the same … so I often hold my "private briefings" with our gurus during those quiet, late-evening hours.)
But I remember this particular conversation with Shah very well – and with good reason. The global financial crisis was in full swing – the stock market wouldn't even "bottom" until the subsequent March (remember, this is still November) – and yet, here was Shah … already talking about the "aftershocks," the changes that would take place AFTER the financial crisis.
Think about that for a minute … players like Bear Stearns Cos., Lehman Brothers, Fannie Mae and AIG have all been leveled (Bear Stearns and Lehman were done). The stock market is in a freefall. There's no clarity, just massive uncertainty, and here's Shah's telling me – with confidence and conviction – what he's certain is going to happen when the (worst of the) financial crisis is over.
In our talk that night, he made five predictions, describing the five "aftershocks" he said were certain to come true. I was so jazzed about this talk with him that I actually turned the conversation into a formal "interview" so that we'd have these prognostications "on the record."
Then, being the journalist that I am, I wrote a story chronicling those five forecasts.
In the months that followed – and you can bet that I was paying attention – each of Shah's five predictions came true.
Every one.
You made great observations about Shah's terrific ability to decipher complex topics for his readers, which is one of the things that sets Money Morning apart as an investment publication. I wanted to share this anecdote to show you just how right you all are.
Thanks again for reading, and for your comments.
And remember, if you have comments or suggestions that aren't related to a specific story, feel free to write to us at mailbag@moneymappress.com.
Respectfully yours;
William Patalon III
Executive Editor
Money Morning
I really think your analysis explains a very complicated topic simply. I do believe until we do something with the high levels of debt the entire ecomony is being pulled down. Businesses do not want to hire due to uncertaintly. The joblessness is increasing and is not limited to the uneducated. Even the educated among us cannot find work. It seems there are forces trying to push us this direction even though we are fighting it. Hope for change for all of us soon.
Having looked at the mathematical expression that calculates the VIX from the actual option prices, it is clear that puts and calls play an equal role. If I understood it right, the article explains the relatively contained levels of the VIX by saying that even though put prices have increased, call prices have dropped, and thus the VIX has not increased as much as one would expect under the circumstances.
I trade the S&P 500 through the ETF, SPY. My actual experience is that when the markets go down and the put prices increase, so do the call prices. In particular, especially if one looks at weekly expiries, the value of the OTM calls remains stubburnly high, (i.e., call prices of a given strike price drop very little even if the market goes down a lot , so that premiums become very high) until very close to expiry.
As if the "market were to assume" that the drop was very temporary and would bounce back within a short period of time. That would be an alternate explanation to the VIX being below the 21 level most of the time.