Fear and Loathing in the Options Market

To this, Ruffy adds: "Most of the investors that really wanted to be hedged are probably hedged by now. And secondly, overall sentiment has changed. While it is clear that bearishness and negativity are still very high, it is no longer panic and extreme fear - instead, the sentiment is more consistent with despondency and disengagement."

While prohibitively expensive premiums have led to a drop in hedging activity using index and nonequity instruments, there's also been a hefty impact on the cost of speculative, directional trades.

"A lot of retail traders limit their activities just to the buying of puts and calls, and that's a very scary trade to be in right now," explains Brian Overby, senior options analyst at Charlotte, N.C's TradeKing. "Even traditional directional option plays -- buying calls or puts -- have become de facto volatility plays because premiums are so high. This is especially true on the call side. If you're a long holder of calls, if the market moves up but volatility comes in, you may get crunched by a large decline in implied volatility. Implied volatility is usually negatively correlated to a market increase."

For an example of this, consider the People's United Financial(PBCT Quote), the New England-based regional thrift that replaced Unisys(UIS Quote) as an S&P 500 component on Nov. 7.

From Oct. 10 to Nov. 14, shares in People's United Financial have registered a 21% gain, compared with a 14% decline for S&P financials as a whole. That said, had an options trader looked to capture some of that upside by buying out-of-the-money calls on Oct. 10, when People's was trading at $15.16, he or she would have paid $1.46 per contract. By Nov. 14, People's shares were at $18.15, rendering those calls in the money by almost $1.

But the value of the contracts had in fact declined by 6 cents in the interim as implied volatility on People's United options came off by 16%. Positive movement in People's share price took the edge of its implied volatility, preventing a correct directional call from being closed out profitably. That, in a word, is "volatility crunch."

Puts, too, have become not just crowded but costly trades to execute in the present market environment. Holding a put on Goldman Sachs(GS Quote), which has seen its share price dwindle to just about a quarter of its 52-week high, seems an obvious strategy in retrospect. Entering a new put position in Goldman today is simply too costly. And with option traders at a loss to determine without equivocation just how much is too much to pay for an option, it's little surprise to see so many traders standing at the sidelines.