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Options: Beware the Volatility Monster

Two case studies are JPMorgan Chase and Visa.
Author:

By Jud Pyle, CFA, chief investment strategist for the Options News Network

VIX this, VIX that -- why is it relevant? The CBOE SPX Volatility Index (VIX) has risen to prominence in recent years, especially among the options-trading crowd. No longer just seen as a "fear" barometer, defined by peaks and valleys, the VIX helps make sense of the wild world of options trading.

Lately, the chatter surrounding the VIX has been that it has been deflating. Since hovering around the 75 mark last fall, the index has slowly declined and is now perched in the 40 area. So what, you say?

Well, today, we're seeing two real-life examples in the financial sector of how reduced volatility can come back to bite call-buyers, especially those holding out-of-the-money positions.

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First up is

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

, which at the time of this writing is up 10 cents to $32, while the May 35 JPM calls are down 3 cents. At the time of this writing, they were crossing the tape at an average of $1.22 per contract.

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Volume is near 14,000 contracts already today, and it appears that the sellers have control of the pits so far. Open interest this morning was 21,621. Interesting play by sellers given that we are likely to hear more about the bank stress tests before May expiration.

Even more interesting is

Visa

(V) - Get Visa Inc. Class A Report

, which was nearly 1% higher in the first 30 minutes of trading this morning, but the out-of-the-money May 60 call is virtually unchanged.

Volatility is coming in on this stock, and what is even more notable is that V doesn't report earnings until April 29! It is typical to see volatility collapse after earnings hit the wire. Not so normal when it dries up in the days leading up the report. About 6,000 contracts changed hands in the first 30 minutes of trading on open interest of 6,562.

Now, we don't know if these positions are being sold-to-open or sold-to-close, and that really doesn't matter. What is important to note is that calls can still be in the red even if the underlying stock is flat or higher. The Black-Scholes model has five dynamic variables, remember, and volatility is among the most dynamic of all of them (along with stock price).

If you remain unconvinced, and think that volatility may ramp up before May expiration, there could be some good opportunities out there, as there is a decent supply of cheap options. But be wary, the VIX monster is holding some of the cards.

Jud Pyle is the chief investment strategist for Options News Network (www.ONN.tv) and the portfolio manager of TheStreet.com Options Alerts. Click here for a free trial for Options Alerts. Mr. Pyle writes regularly about options investing for TheStreet.com.

Jud Pyle, CFA, is the chief investment strategist for Options News Network. Pyle started his career in finance in 1994 as a derivative analyst with SBC Warburg. After four years with Warburg, Pyle joined PEAK6 Investments, L.P., in 1998 as an equity options trader and as chief risk officer. A native of Minneapolis, Pyle received his bachelor's degree in economics and history from Colgate University in 1994. As a trader, Pyle traded on average over 5,000 contracts per day, and over 1.2 million contracts per year. He also built the stock group for all PEAK6 Investments, L.P. hedging, which currently trades on average over 5 million shares per day, and over 1 billion shares per year. Further, from 2004-06, he managed the trading and risk management for PEAK6 Investments L.P.'s lead market-maker operation on the former PCX exchange, which traded more than 10,000 contracts per day. Pyle is the "Mad About Options" resident expert. He is also a regular contributor to "Options Physics."