Volatility Underperforming...What Does it Mean?

by Jay Pestrichelli on July 12th, 2012

Over the last few days, the VIX, measure of volatility for the S&P 500 has been underperforming. In other words, it should be higher based on the poor performance of the SPX. For example:
  1. 1. 7/6 the SPX was down 13 points
  • a. VIX was down .40
  • b. It should have been up closer to  1.05
  1. 2. 7/11 the SPX was flat (although only from a bounce back at the end of the day)
  • a. VIX was down 0.77
  • b. It should have been flat to up .35
The days in between were normal and the VIX has yet to correct for its trailing performance. Add to this that other indices like the NASDAQ or Russell 2000 are notably underperforming and one wonders what is going on with the spot VIX price.

The VIX is mathematically defined by the implied volatility in the options of the SPX. So when the VIX goes down, it means that there is more selling of options than buying. Looking at the current and next month of the SPX options market, we can see that the calls are being sold as their extrinsic value (time and volatility) is skewed lower than the puts at similar strikes.

While this has been the case for a while, anyone who has been selling calls to pay for part of their put protection (collars) has been aware of this. Typically when we see lower volatility it means that traders are less willing to speculate as they show a appetite for less risk. In other words, the are selling options more than buying them.

So when the market is showing signs of weakness and the VIX is underperforming, we can interpret it as traders sitting tight despite the potential for some quick money to be made on a downswing. For example, they maybe writing calls on stock they hold as opposed to selling it and getting bearish. Said another way, they maybe trying to earn a little income while they wait for the storm to pass.

At Buy and Hedge, we regularly sell calls as a source of income to pay for our hedges. Which means in more volatile times we earn more from that activity. However in this environment, selling calls is generating less and less money despite the market moving down. Admittedly not a great combination.

We’ll tell you that sticking to a disciplined set of hedging activities is still the right play. Keep on selling those calls to pay for your puts and if the market moves up through your strikes, just roll them forward and don’t let them lower volatility discourage your selling for income.

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