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Fear Drives a Feeding Frenzy in VIX, VXX Options

Examining the uptick in options activity on volatility-based products

by 4/2/2012 3:17 PM
Stocks quoted in this article:

The following is a reprint of the market commentary from the April edition of the Option Advisor, published on March 22. Prices and the chart are as of the close on March 22. For more information or to subscribe to the Option Advisor, click here.

My commentary for this month will focus on option activity for the volatility-based option products and for the silver exchange-traded fund, as well as on some brief technical takes on the Financial Select Sector SPDR Fund (XLF), Wal-Mart Stores (WMT), and the Euro Stoxx 50.

First, various measures of option open interest for the two major volatility-based option products have soared to record levels recently. Call open interest on the CBOE Volatility Index (VIX) reached an all-time high of 4.22 million contracts on March expiration day, while put open interest on the iPath S&P 500 VIX Short-Term Futures ETN (VXX) peaked at an all-time high of 1.17 million contracts at March expiration, and shows every indication it will achieve yet another record level by April expiration. (All option data in this commentary are courtesy of

Activity in volatility-based options has traditionally been driven by periods of stock market weakness that contribute to a fear-based surge in the implied volatility of index options, with fears of a more extensive market decline (or, perhaps, "the big one" in the form of a market crash) further stoking the volume and the pricing of these volatility options.

But the current feeding frenzy in the VIX and VXX options is difficult to explain on all fronts, viz.

  1. Realized volatility of the S&P 500 Index (SPX) this year has been extremely muted, with most measures of S&P historical volatility registering in single digits since February.
  2. The stock market has been in a slow, steady rally in 2012, with the biggest short-term decline on a closing basis registering an anemic 2.25% from March 1 through March 6.

So why are these volatility-based options products -- designed basically as hedges against a disastrous market decline -- still front and center in terms of activity and interest? Most likely for the same fear-based reason 10-year bond yields plunged this year to levels last seen at the peak of the financial crisis in December 2008, and investors still feel a lot more comfortable holding tens of billions of their assets in the bond-laden Pimco Total Return Fund (which is barely in plus territory this year, and shows a three-year total return of 30%, compared to over 100% for the S&P) than investing in traditional equity funds.

And it would be inconsistent with stock market history and with the interplay between investor psychology and stock price levels for the market to be at or near a peak when such major components of investor behavior are fear-based rather than greed-based.

Second, the huge rally in the iShares Silver Trust (SLV) from early 2010 through April 2011 -- a period over which this asset roughly tripled in price -- was accompanied by:

  1. Generally rising short interest.
  2. Generally rising option implied volatility.
  3. Generally rising call option open interest.

In marked contrast, the period since the April 2011 peak -- which, at its worst, saw this asset decline by nearly 50% -- has been accompanied by a major reversal of all three of these trends.

Call open interest in SLV peaked at May 2011 expiration at 3.4 million contracts. At March 2012 expiration, SLV calls registered just 1.9 million contracts, and currently total 1.7 million. The 30-day implied volatility for SLV options established twin peaks around 70% near the May 2011 price high and the September 2011 secondary price peak. SLV 30-day implied volatility subsequently plunged, and on March 19, bottomed (for now) at 29.5%, the lowest IV level since late 2010. On the short interest front, peaks were established in April and June 2011 at about 37 million shares. The current level of 25 million shares is well below the peak, though it is somewhat encouraging that it has recovered from the lows at 20 million.

Daily Chart of SLV with Short Interest since January 2010

The bottom line is that the huge 2010-2011 SLV rally was characterized by a "fever pitch" of short selling, call option accumulation and option IV levels. This fever has broken in spades, and, if past is prologue, then before committing to the long side in SLV traders should now be on the alert for indications that the bottom is firmly in place for each of these three indicators to potentially capture the potential for yet another feverish rally.

Finally, some quick technical takes:

  1. Financial Select Sector SPDR (XLF) -- While there remain way too many analysts who have stuck to their bullish guns on the big banks, the fact that XLF has broken out above significant resistance at the round-number $15 level and at its 80-week moving average should give pause to those looking to short this ETF. Perhaps of key significance will be the ability (or inability) of Bank of America (BAC) to take out round number resistance at $10, as well as resistance at its 320-day moving average just below $10.
  2. Wal-Mart Stores (WMT) -- While unfortunately on the list of just about every individual investor's favorite holdings, WMT has now spent a dozen years unsuccessfully attempting to take out resistance at the $60 level. Will 2012 be the charm? A disappointing March earnings report was certainly not helpful, and my choice would be to continue to play the retailing sector from the long side through the medium of the SPDR S&P Retail ETF (XRT), which has been blessed by a much smaller weighting in WMT shares than would be indicated by market capitalization.
  3. The Euro Stoxx 50 closed today at 2,530, down from its very recent peak just above 2,600. The 2,500 level on this key index of the health of the European markets is hugely important and should be watched carefully, as should 2,557, which represents a 10% year-to-date gain.

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