EYE ON OPTIONS: THE VIX TESTS HIGHS AGAIN

Last week I walked through the volatility environment and our view that, despite signals that VIX might be starting to decline somewhat, it would still remain at nosebleed levels on a historical basis through the coming months.

This week vol. levels again ripped with Thursday’s spike pushing the VIX to close above 80 to a level of 80.86, actually higher than the close on October 28th. Thursday also marked the first time that the VIX has closed higher than the realized 30 day volatility for the cash S&P 500 since Oct. 27th. VIX futures maturing in December and January continued to trail spot levels, hovering near the 50 day moving average. The key takeaways from this market action were changing liquidity patterns and put/call divergence.

Although the aggregate, Index and Equity Put/Call ratios rose sharply in late week sessions, the Index PCR has continued to make lower highs since early October as buyers continue to pay inflated prices for insurance.

Along with a general decline in volume from last month’s historic levels, many market observers noted that a lot of players seemed to be sitting on the sidelines.

Hedge fund redemptions are a large factor in declining volume, but so too are rising yields in the corporate bond market. For the past 5 years, the credit default swap market has been a primary source of trading activity for out-of-the-money equity put options as dealers sought to hedge tails risk on the default insurance they were selling (and arbitrageurs sought to capture spreads between the two markets). With the new reality starting to hammer the bond markets and volume drying up in CDS for names that are in clear danger of default such as auto makers and financials, there is a an asymmetrical impact on liquidity as those players leave the market.

In the thinner market for options on futures the spike had a more pronounced impact as the class of funds known as “premium sellers” found it impossible to get out of the way of runaway trains without causing price spikes late this week. The premium sellers as a class will likely be extinct after this month –one well capitalized manager who is a personal friend of mine (although we are odds intellectually on risk and investment) already registered a draw-down of over 59% in Oct. and will likely be busted out if he remained short volatility into Thursday. Their departure from the scene as cheap sellers of insurance on the S&P and other major indices to market makers will have a direct impact on liquidity in the equity options market.

Taken all together, this creates tremendous opportunities for investors that normally shy away from the options market to capture outsized returns, provided they have the correct investment duration, fundamental conviction and do their homework.

The leveraged matador speculators and arbs are gone, the only providers of liquidity in this market will be people that actually understand the fundamentals of the underlying companies and can properly assess the risk. Those investors will be rewarded handsomely.

As always feel free to contact me with any question about strategies at

Andrew Barber
Director