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An old friend and mentor used to say, "The worst is never when you can say, 'This is the worst.'" Each and every market downturn we go through has the feel of being the worst, but when we look back at the charts with the benefit of hindsight, we often have to strain to remember the cause of that particular painful episode.
Regardless, high volatility contributes to a decline's end by raising the cost of put option insurance. At some point, investors look at the cost of the put options, calculate the time premium thereof and compare it with the potential decline in the stock to see whether buying puts makes sense. If the answer is no, they do not buy the put, and the option market makers who would have written those put options are not forced to sell the underlying stock as a hedge. Price and Volatility Rising TogetherA reporter asked me early last week to reconcile the rising level of the VIX with a stock market that was then just points away from its all-time nominal high. Implicit in the question was the oft-observed relationship between rising volatility and falling stock prices. I responded that the 1995-1998 market was characterized by price and volatility rising together. Not only were many investors feeling nervous about the market's level, options market makers were having to charge for the greater dollar risk they were assuming in their positions by virtue of the bull market. A 1% move in the market with the S&P 500 at 900 carried twice as much dollar risk as it did with the S&P 500 at 450. I also recalled a chart I had done in early 1999 with the day's range on the VIX mapped against the S&P 100 (OEX), then the basis for the volatility measure. It showed a very distinct pattern of a gradual decline in the VIX as price rose, a shock higher on some pullback now forgotten and another decline as price rose. Here's an updated version of that chart from May 1, 2003, onward, with the VIX's range mapped against the S&P 500. Friday, July 27, is marked; Thursday, July 26, is to its immediate right.
The pattern is identical to the one I constructed for the 1990s (not shown in the interest of space). Three pullback points in the market since June 2006 are noted; the previous two set the market up for the expected combination of volatility falling along with a rising index level. The post-March 2007 rally never saw the VIX decline to previous levels; as with the 1990s market, option traders started to demand more insurance premium to ply their craft. You may ask whether the pattern is different for a bear market, and the answer is yes. If we repeat the analysis for the March 24, 2000-Oct. 9, 2002, sample, we fail to see either the VIX jumps on pullbacks or the declines on rallies seen in bull markets. Option traders are far less likely to sell volatility systematically when the next downturn could start tomorrow.
Stocks and ConvertiblesAs promised in a Columnist Conversation posting, it is time to update an analysis from June 2006 on the relationship between convertible bonds and stocks. As we are worried about credit spreads and deteriorating credit quality, let's focus solely on high-yield convertibles, as opposed to investment-grade convertibles. The two markets have performed very differently since October 2002. Investors in high-yield have been rewarded for their assumption of risk.
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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.
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