Remember that whole incredibly annoying stretch of time when someone got on TV and said "Risk On" or "Risk Off" every 30 seconds? We had a brief, glorious respite for the early part of this year, but guess what, it’s back.

"Risk On, Risk Off" was just 2011-speak for "high correlation." When everyone got worried about Europe falling into the Aegean Sea (or something like that), they started treating all asset classes as one single entity. Buy Yen and U.S. bonds! Sell commodities, drop anything with the word "euro" in it, and unload any stock, no matter what the underlying company does.

As you can see from this video off Bloomberg, correlation within the U.S. stock market has picked back up. There is a myriad of ways to quantify correlation (and none are perfect), but presumably if you maintain a consistent way of measuring it, you’ll at least have an apples-to-apples comparison.

The look in the video measures correlation over the past four years and shows it took a severe dip in early 2012 before rallying in recent days to about the average levels when measured over the past four years. It's still considerably off the highs from last fall so is essentially hovering around a middle ground, but trending higher.

Why dredge this all up? Well, it has huge meaning for options pricing.

Implied volatility in SPX, illustrated by proxy via the VIX, has two main drivers. One is the implied volatility of the component stocks themselves. Obviously, the higher the volatility of the components, the higher the volatility of the index. The other is the degree to which the components move together. If they’re individually volatile but moving relatively independent of one another, than index volatility will remain muted. But if they start moving together, (i.e., with higher correlation), than index volatility will rise.

Consider an index comprised of only two stocks, Apple and Exxon. Say they’re both moving at a 50 volatility pace. If they’re moving pretty much in the same direction most days (a high correlation), the index volatility will approach 50. If, however, they move at that same volatility pace but generally in indifference or opposition to one another (a low or even negative correlation), then the index itself will move at a near-zero volatility pace.

Back in the real world, the rising correlation we’ve seen the past couple weeks has definitely seeped into the options markets. Meanwhile, the VIX has risen at a relatively faster pace than individual stock volatility. We’re far from at extremes yet, but this is a trend worth keeping an eye on.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.

Should we have seen the JPMorgan Chase & Co. (JPM) mess coming? Someone apparently did, as per my friend Steve (not Stephen A.) Smith on Minyanville:

"It appears that once again someone's bunny had a good nose and they dug into the option patch to bring home a bunch of tasty carrots just in time for Mother's Day.
Yesterday afternoon following the close, JPMorgan (JPM) held a surprise conference call to announce significant losses in structured-credit trading.
Before that, the JPMorgan May $41 put options -- the weeklies that expire today [Friday] -- saw 13,843 contracts trade... This morning, open interest in that strike came in at 7,100 contracts, nearly doubling. And according to ISE data, 65% of the transactions were done at the offer price, suggesting fresh buying.
The puts traded between $0.22 and $0.50 over the course of the day with the largest transaction being 500 at $0.35 per contract."

With JPM opening Friday in the 37s, that's... a lot of coin for somebody. And rest assured -- the SEC will investigate all trades from Thursday, seize a tiny portion of the ill-gotten profits, and settle with the inevitable class action suit by 2017. At which point any victims will receive 5 cents on the dollar of a trade they will have long since forgotten.

But I digress.

More importantly, what's the real lesson here? Can we follow unusual options flow and avoid and/or profit from situations like this?

The answer is that it's not clear. Trades like this one on JPM stick out like red flags in hindsight, and most likely triggered systems designed to track unusual trading. The problem is there's a very low signal-to-noise ratio. There's lots of unusual trading out there, and relatively few instances precede actual implosions like this. Of course, you don't have to win every time -- or even half the time -- because the gains of actually catching one right dwarf the relatively small losses. I mean, if you jumped in and paid $0.40 for expiring puts in JPM, you would risk... $0.40.

I do understand why plays like this entice many. If it entices you, keep in mind the Principle of Expected Gains. If you make 10 times your money on a trade, but you need to make 13 trades to hit one of those 10x plays, you're a net loser. If you only need 8 trades on average for the big win, you're a winner. Maybe. (I say maybe, because if you pay an options service to generate ideas like this, you have to factor in that expense.)

I'm kind of agnostic on whether following flow works or not. I tend to think it depends on the end user more than anything else. I would just advise looking at the entire picture and remembering all of the small losses that precede the monster win.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.