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Mark Sebastian: Volatility Analysis

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If there is a story from Friday, it is not that the DJIA was down a few points or SPX was up a few, but rather the absolute torching the CBOE Volatility Index (VIX) took toward the end of the day. VIX is now pointing back toward more of the same and less at the 10-year falling apart again. The month of June saw an incredible move in market volatility, as did the month of July. In a matter of weeks the SPX dropped from 1670 to 1560 and Back to 1670. That kind of movement, while not unheard of, is certainly unusual and caught me a bit flat footed. I saw the bounce on the bottom, but not the move back to new highs.

The only thing stopping me from hopping back into a short vol play has been volatility. A strong fast move higher is generally not healthy. High volatility on an upswing points toward weakness not strength. Then in the last 10 days or so, the market shifted from riddling to volume. While the SPX has rallies in the last few days the move has crawled at a volatility in the mid-single digits.

The only shoe left to drop was option prices and those appeared to have dropped on Friday. Now the only question in my mind is 'How long will VIX stay beneath 15?' I think we will know by a week from Friday. If VIX does not rally into the non-farm payroll number very much and NFP is a non-event, VIX could be super low for an extremely long time.

Based on all of this, despite low volatility, options are quite overpriced and there is plenty of chances to sell them in the right conditions. I would be happy to buy puts in VIX and play the convergence of future to cash, especially with August being a short month. iPath S&P 500 VIX ST Futures ETN (VXX) is probably going to continue to deteriorate and should be a nice short for the time being. If the VIX manages to break 15 then think about getting out, but until then I would stay short.

If I had to buy a straddle on an index it would probably be SPX. With the upward momentum the market is showing even if the move is slow there is still a good chance that a straddle might win. Even so, index volatility is probably over priced.

There is some opportunity in individual stocks. Traders have been, based in part on a low VIX, been crushing the IVs of many big name stocks, even after big moves. Recently, on the heels of HUGE overnight movement, both Chipotle Mexican Grill (CMG) and Google (GOOG) saw their option prices murdered by the street. A combination of straddles in names like CMG, GOOG and maybe even Apple (AAPL) versus a sale of volatility using VIX or SPX could be highly effective in this kind of market.

For those that want to sell premium in equity names, I think the game will pay off well, but be selective and smart about the names sold. It does not make sense to sell a call or put spread on a stock that is at multi-year lows in IV. Look at commodities and interest rate products or precious metals for decent options sales.

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At the time of publication, Mark Sebastian held positions in VIX.


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