Fear and Loathing in the Options Market

As volatility remains at crisis levels, more and more retail option traders are getting sidelined by high costs. Volumes are undeniably lower, premiums are higher, and spreads are wider. Still, there are strategies option traders can use to survive the tide.

These days, it's another day, another close above 60 for the volatility index (VIX), the composite measure of implied (or anticipated) volatility in the S&P 500 that provides the benchmark for the pricing of U.S. options. Much is made in market commentary about the relative elevation in the VIX, which is also casually regarded as the barometer of "fear" in the market. The impact on option prices is a collateral effect.

What's in a Reading?

While the VIX provides a benchmark for the pricing of options -- contracts to buy and sell underlying stocks that were originally conceived as insurance products -- the reading is not derived directly from the Black Scholes pricing model used in the calculation of individual option contracts. Since 2003, the VIX has been derived from a real-time calculation that averages the weighted prices of out-of-the-money puts and calls on the S&P 500 index. The resulting measure provides a benchmark for anticipated volatility in the index as a whole over the next 30 calendar days.

Over the past five years, since the new calculation was introduced, the index has averaged just 17.39, having made four tests of the 50 level during periods of crisis over the preceding decade and a half (most recently after 9/11).

The index peaked out at 37 at the dawn of the credit crisis in August 2007, and this level went largely unchallenged until the collapse of Bear Stearns on March 17, 2008. Many observers marveled at the relative composure -- not to say complacency -- in the volatility index.

But as fears about the length and breadth of global recession have taken hold throughout the investor community, VIX volatility has spiraled higher. Since Oct. 6, the index has closed above a 50 reading every day but one (Nov. 4, when it dipped to 47.73), setting a new high just north of 80 on Oct. 27. With the volatility index staying so high for so long, options -- both call and put -- are like Manhattan real estate: expensive no matter how big they are or where you go.