The spike in volatility accompanies the market decline

by Wayne Ferbert on February 21st, 2013

The market decline on Wednesday was accompanied by a significant increase in the measure of market volatility. Obviously, as markets move significantly, the measure of volatility increases. However, moves down tend to cause more significant increases in the VIX than market increases tend to cause.
If there is one lesson to remember here it is the tendency of the VIX to increase faster in a sharp down market than in a sharp up market. The decreases in the market tend to really drive the cost of protection up – which drives the VIX up disproportionately.
The VIX is a measure of the volatility you see in the futures/options market. The volatility in the options market is a key driver in the value of call and put options. The increase in the VIX, if it holds, is going to drive the value of protection up. Of course, it is correspondingly going to drive up the value of covered calls also.
The spike in volatility today is the single biggest upward spike in over 3 months. The VIX moved up 2.37 points from 12.31 to 14.68 – a 19% increase in one day.
For our primary strategy of using collars, the increase in volatility will be key to monitor. If it holds up or keeps increasing, we will see the covered calls we write for near months increase in value. On the flip side, the protection we buy is going to increase. We have been encouraging our readers to buy long-dated protection as it has traded at the lowest levels we have seen in 5+ years.
If you have locked in the protection at historically low levels, then the increase in covered call premiums should help to fund the cost of these puts.
But don’t count your chickens yet. The increase in the VIX is a one-day move. You’ll need to monitor it for the next 2-4 weeks to see if it sticks. If it does, then look to take advantage if you were lucky enough to lock in your lower protection costs.

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