CBOE Volatility Index


hit a low of 14.30 Wednesday morning and dipped to its worse levels in almost four years. The last time the volatility index traded in the mid-fourteens was in July 2007. To some market watchers, the so-called "fear gauge" is sending an ominous signal. VIX's low readings are a sign of bullishness and complacency that sometimes surface when things get a bit frothy on Wall Street and the investor sentiment reaches market-topping levels.

Looking beyond VIX as a sentiment indicator, there are a couple of other reasons the index might be falling. VIX opened at 14.31 today, which is incidentally the April expiration for the volatility index. Unlike most other contracts, VIX options expire and settle on Wednesday's. It's the Wednesday 30 days prior to the third Friday of the following calendar month, according to the Chicago Board Options Exchange CBOE. Confused? Me too.

Suffice it to say, April options on the VIX expired today and the settlement value for the index is 14.86. In other words, any call option that has a strike price greater than 15 is expiring worthless. Now note that, on March 16 when fears about the Japan nuke crisis rattled equity markets around the globe, VIX hit multi-month highs of 31.28. At that time, there was a flurry of activity in VIX April call options. Consequently, there is a lot of open interest in VIX calls.

The April 30 calls, for example, had open interest of 140,713 contracts before the expiration. Consequently, 140,713 contracts of April 30 calls are expiring worthless. The contract is 89.1% out-of-the-money! Only three contracts - the April 10, 13, and 14 calls - will expire in-the-money. Combined, the three contracts have open interest of just 812 contacts. The remaining contracts, which have strike prices ranging from 15 to 80, had collective open interest is 1.15 million contracts. So, 812 VIX calls expired in-the-money and 1.15 million expired out-of-the-money.

Maybe the VIX options distorted the VIX today? After all, a tenet in the options market is that a price of a stock or index tends to gravitate towards a price point that causes a lot of pain at the expiration. VIX at 14.86 probably caused a lot of pain today.

Of course, the volatility index is also reacting to market conditions. Although the S&P 500 took a hit Monday after Standard & Poor's lowered US's credit rating, the market was steady Tuesday and the S&P is rallying following a round of upbeat earnings reports Wednesday. The index has now rallied 5.9% since the March 16 lows.

In addition, since VIX is a measure of expected or implied volatility IV based off of S&P 500 (SPX) options prices, it has been falling because the market has been trading relatively quietly lately. The 20-day statistical volatility SV of the S&P 500, which is based on the closing prices of the SPX over the past 20 days, is only 8%. Since VIX is based off of SPX options, it makes sense that it will be affected by the actual or SV of the index. This is true of any options contract. The implied volatility priced in the option will normally reflect both actual and expected volatility of the underlying instrument. In other words, since SPX actual volatility is only 8%, VIX near 15 is relatively high.

In conclusion, if VIX fell to its lowest levels since July 2007 Wednesday with help from the expiration and because of low levels of actual volatility, it might not be producing the market-topping readings that some market watchers fear. That is, while the low readings from the "fear gauge" do reflect some bullishness and complacency among investors, other factors are affecting the volatility index as well. Still, it's a trend worth watching. The last time VIX was near these levels in mid-July 2007, the S&P 500 was trading around 1550. One month later, it hit a low of 1370, which represents a four-week market decline of 11.6%.

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At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.

In addition to writing market commentary and trading-related books and articles, Fred has also worked as an instructor, educating investors on advanced topics like measuring volatility, the benefits of sector rotation and the risks and potential profits from trading around earnings. An active trader himself, with over 15 years securities industry experience, his market observations and analysis of the options market are featured regularly in the financial press including Barron's, Reuters, The Wall Street Journal, and Bloomberg.

On April 27, TheStreet's OptionsProfits is hosting a webinar featuring Mark Sebastian of Option Pit. During the presentation, we will explain what the VIX is and the mechanics and pricing behind the product, what the difference is between VIX futures and VIX cash, as well as using VIX for speculation and a hedge. To request a spot for the presentation, please email: jill.malandrino@thestreet.com

OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.

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