Volatility Readings Will Not Mark the Bottom

Myths die hard. Make room in your trash bin for the notion that VIX volatility readings that are over (insert arbitrary number derived in an ad hoc manner from a small-sample data-mining operation here) mark a bottom in the stock market. Wrap it in a newspaper, if your town still publishes a dead-tree edition, and place it lovingly next to Dow 36,000, Stocks for the Long Run and anything ever written extolling the virtues of diversification.

I cautioned in a Columnist Conversation posting last Wednesday against selling the VIX at 57.88; by Friday it punched to 76.94 before closing at 69.95. That advice was offered as opinion; I thought it best to elaborate on why the VIX could go higher in the present crisis environment.

The analysis will be split into two parts, because of considerations of length, with the second part appearing next week.

Let's get to the most complex part of the argument first, and that is a revisit of a May 2007 column on volatility trading. I wrote at the time:

[T] he cash market for trading volatility grew up around variance swaps, whose payoff is linked not to the implied volatility measured by the VIX but rather the forward realized variance of market returns. As an aside, the future on the VIX, last discussed here in March, is really much more of what is called a forward-start variance swap than something linked to the ups and downs of the VIX itself.

Realized variance differs from implied volatility in three important ways. First, implied volatility is forward-looking and represents the price of insuring against uncertainty, while realized variance is a backward-looking measure of what actually transpired. Second, trading implied volatility with options involves upfront costs and exposes traders to time decay and interest rate costs of carry.

Third, the formula for calculating variance effectively squares volatility. That means that as realized variance jumps, the payoff for being long variance in the swap increases far more rapidly than does the payoff for being short variance in the swap as realized variance falls.

This mechanism has operated with a vengeance during the crisis. Anyone who has written put options has lost thrice-over. The first loss is the drop in the underlying stock or index; this is the intrinsic value portion. The second loss comes from the expansion of volatility; this is the time premium portion. The third loss comes from the expansion of put option delta as the market declined. Delta is the expected change in the option's price for a change in the underlying asset's price. For a put option, it can go to -1.00.

Let's suppose you took the bait on Friday, Sept. 19, 2008, when stocks rallied on the rumors of a federal bailout, the TARP plan. The S&P 500 settled at 1255.08 that day, and you thought you would pick up some free money by writing the October 1125 put option. That option settled at $10.15, and as it was 130 index points out of the money, a moneyness of 89.64%, it seemed like a good way to have the market pay you $1,015 per contract for being so smart.

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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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