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Published: October 27, 2009
CNBC is infatuated with the VIX.
The Volatility Index (VIX) is a measure of implied
volatility of option premiums. Simply put, it's a measurement of
investor fear. If investors are worried about stocks and about
the potential for a loss, the VIX rises. As investors get more
comfortable holding stocks, the VIX falls.
Last week, CNBC ran dozens of segments on the VIX.
Seriously, by Wednesday or Thursday, it seemed as though every
few minutes some talking head on CNBC was spouting off about the
VIX making a new low on the year. They viewed this as bullish,
since investors were less fearful and, therefore, more inclined
to take on risk and buy stocks.
I was looking at something else -- the options on the VIX. And
those look wildly bearish. Let me explain...
VIX options are different than
most stock options in that they're
"European" settlement. This means
options on the VIX can only be
exercised on the option-expiration
date -- as opposed to "American"
style options, which can be
exercised anytime. This eliminates
the arbitrage potential of buying an
option, immediately exercising it,
and then unwinding the position for
a profit.
So VIX options will routinely trade
at a discount to their intrinsic
value.
This is why I don't trade VIX
options. There's no arbitrage effect
and no certainty that an option
trading at a discount to intrinsic
value will generate a profit.
But I watch the premiums on VIX
options because they provide HUGE
clues as to where the market will
move in the short term.
For example, last Friday, when the
VIX was trading at 21, the November
22.50 puts had an intrinsic value of
$1.50 -- meaning an investor could
have bought the VIX for 21 and
exercised the right to sell it for
$22.50 and pocketed $1.50. That's a
guaranteed profit of $50 on each
contract under normal circumstances.
The options were trading at $1 -- a
$0.50 discount to intrinsic value --
because the options can't be
exercised until the
option-expiration date next month.
So no one could capture the gain
instantly. They'd have to wait and
see where the VIX closed on option
expiration day in November to
determine the profit.
Bear with me, because this is
important...
Traders who were buying these
options were betting the VIX would
be above 21.50 on option-expiration
day in November. In other words,
even folks who are bearish on the
VIX are counting on volatility
increasing.
Folks who are bullish on the VIX are
particularly bullish. The VIX
November 22.50 calls, for example,
were trading for $2.50. Traders who
were counting on the volatility
index rising in value were betting
the VIX would be over 25 by
option-expiration day in November.
VIX bulls are paying a huge premium
for the right to buy VIX at 22.50.
And VIX bears are taking a discount
to intrinsic value on the puts.
All these traders are betting on an
increase in volatility. Increases in
volatility are typically associated
with declines in the general stock
market. So judging by the VIX option
market, it's reasonable to expect
stocks to come under pressure over
the coming days and weeks.
-- Jeff Clark
Editor
Growth Stock Wire
Editor's Note: This
article originally appeared in
Growth Stock Wire. |
