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July Option Advisor Commentary

A closer look at the CBOE Market Volatility Index and the 10-month historical volatility of the S&P 500 Index

by Bernie Schaeffer 7/8/2009 8:10 AM


The following is a reprint of the market commentary from the July edition of the Option Advisor, published on June 25. Prices and the chart are as of the close on June 25. For more information or to subscribe to the Option Advisor, click here.

This month – some musings on volatility and the CBOE Market Volatility Index (VIX).

WEEKLY CHART OF VIX SINCE JUNE 2007

  • You can't refer to volatility without defining your time horizon. The 10-month historical volatility of the S&P 500 Index (SPX) is currently at 49%, its highest level in modern times. But the 10-day historical volatility of the S&P is just 22% and has retreated in recent months to its lowest levels since mid-2008.

  • Is the market currently volatile? Looking at long-term volatility, the answer is an unequivocal "yes." But short-term volatility is only modestly above that of the bull market days of 2007. And intraday volatility has been almost non-existent in recent weeks. There have been numerous intraday periods during which minute-to-minute volatility has retreated below 10% (and even below 5%) for hours at a time.

  • You can't refer to the cheapness or the richness of the Chicago Board Options Exchange Market Volatility Index (VIX) outside the context of historical volatility. The VIX is, first and foremost, a measure of the anticipated volatility of the near-term options on the S&P 500 Index, and the most important clue over the years to the current level of the VIX has been the short-term (10-day or 20-day) historical volatility of the S&P (the VIX calculation doesn't exactly equate to a historical volatility but it is close enough). So the use of the VIX level as a "fear gauge" must always be assessed net of the major influence of historical volatility on the VIX. While it is tempting after today's VIX implosion to less than half its peak levels in January to suggest that investor fear has dissipated to dangerously low levels, this assessment is seriously complicated by the fact that the VIX is not "low" in the context of the recent volatility of the S&P.

  • Activity in the options market can and does influence realized volatility levels. If options players are comfortable that volatility will not explode and are leaning heavily toward selling premium, this serves not only to depress the VIX but to dampen realized volatility through the hedging process, as well as ultimately cause the market to be more vulnerable to volatility shocks. So there is a sentiment component to realized volatility, which only complicates the process of trying to isolate the "fear component" of the VIX, and this has been further complicated in recent years by the activity in the options on the VIX that also have a major influence on VIX levels.

  • You've probably been told many times that low volatility environments are ideal for selling option premium and option buyers thrive in high volatility environments. But the real answer lies in how the directional component of price movement plays out. A low volatility environment with a persistent directional bias will seriously compromise strategies like covered call writing, on a relative basis if the market is rising and on an absolute basis if the market is falling. And a high volatility environment with little directional movement will defeat the option buyer. This all boils down to the fact that option buyers are paying for volatility, but their payoff is in directional price movement. Keep in mind that the major option pricing models are volatility-based, and operate according to the much discredited assumptions of the efficient markets theory, which is devoid of consideration of such pesky subjects as persistent directional movement and market bubbles and crashes.

  • Equity volatility is seasonal. According to a recent study by Larry McMillan: "There is also a seasonality to VIX trading patterns. ... You can see several patterns (over the past 20 years). Early in the year, there is typically a small peak in VIX in January, followed by a slightly higher one in March. Then it goes into a decline during the spring and into mid-summer. It probably comes as a surprise to no one that the low in volatility occurs around July 1st of each year. What might come as a surprise though is that volatility typically rises quite a bit during July and August. Then it really gets going in the fall -- In September and October, when the stock market typically has major declines. It peaks in October. After that, volatility becomes surprisingly docile for the rest of year, until by Christmas it is almost back at the July lows. Not every year follows the pattern exactly, but most are a reasonable approximation. 2008 followed quite closely, and this year the pattern is typical as well." So is it time to assume that the VIX will rally according to these past seasonal patterns? Perhaps, but I'd also suggest the possibility, based in part on the ongoing compression of historical volatility, that the VIX might continue to decline to surprisingly low levels – perhaps as low as 20 - before it bottoms.

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