The Option Market's Summer Vacation

The recent sideways action in the stock market has impacted options volume and volatility.
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This summer, the stock market has confirmed the perception that these are "quiet" trading months. After a huge run-up this spring, which took the S&P 500 up 20% in a two-month period, the index has been bound within a 5% trading range during June and July. And for practical purposes it's been even narrower, as nearly 80% of the volume of the past two months has occurred between 980 and 1000 -- a mere 2% range.

The issue of whether this is a healthy consolidation (bullish) or a failure to press higher (bearish) aside, the impact on the options market of this sideways action has been to drive down both volume and volatility. The lack of trades is being felt most acutely on retail trading desks.

"Obviously the bear market drove away a lot of the individual investors, but I'm a little disappointed in how slow people are in returning," laments Mike Schwartz, chief option strategist with Fahnestock's Oppenheimer division. Schwartz notes that earnings have generated a moderate pick-up in interest but says it's issue-specific. "We've seen some speculative activity in front of reports, specifically in some tech issues," Schwartz said.

Isolated Bets

Some of the names that saw a surge in volume a day or two ahead of their earnings included


(KLAC) - Get Report





Sun Microsystems

(SUNW) - Get Report

. This week there has been a small build-up in call buying ahead of


(CMCSA) - Get Report

earnings release on Thursday.

Stocks that moved sharply after earnings reports coincided with a commensurate spike in option trading as traders scrambled to adjust positions to new price levels and outlooks. For example,



made a cameo appearance among the most actively traded options, after a disappointing earnings report sent its shares down 16%.

Many of the biggest moves were gains in the supposedly sleepy manufacturing stocks such as


(CAT) - Get Report


Dow Chemical

(DOW) - Get Report



(MMM) - Get Report

. Their options markets received a nice blip of activity as these normally subdued stocks surged in price.

Unfortunately, neither the upfront speculation nor the postearnings flurry signals a broad or sustainable increase in options business for the remainder of the summer. It also seems to indicate that most investors still view options as somewhat risky and to be used sparingly rather than as a money-management or hedging tool.

The recent rally in stocks and decline in option volatility has made covered calls less attractive, but proponents emphasize the long-term nature of the strategy. "I've been using overwriting and covered calls as a cornerstone of portfolio management for over four years now," said Eric Yamin, vice president of Morgan Stanley's Private Client group, whose clients are high-net-worth individuals.

"These people don't necessarily need to make any more money, and while they absolutely understand and buy into the concept of generating income through a disciplined covered-call program, they are nonetheless emotionally unsettled when stocks rally and the gains are limited." Yamin likes to remind people to view overwriting as a means of generating income on a steady yield basis rather than producing capital gains.

Say Anything

A major topic for debate has been the decline of the option market's volatility index, or VIX, below 20 -- its lowest level in 15 months. Many people, particularly those in the bear clan, have been citing the low VIX reading as a sign of complacency and a signal that a downward price move is imminent.

"The fact that it has dipped below 20 has brought out a whole new round of bearish forecasts from the same crowd that was wrong two months ago, when they said VIX dropping to new (relative) lows below 25 would be bearish for the market. Are these guys dense or what?" asks Larry McMillan, president of McMillan Analysis, an option-based trading and research firm. McMillan has been one of the few "experts" that has steadfastly, and thus far correctly, maintained that a declining VIX is actually a positive signal at the outset of a bull market or in marking a bottom. This statement is born out of research, not bombast.

In his most recent issue of

The Options Strategist

, McMillan performed some diligent research to support his conclusion that the VIX generally declines during a bullish-market phase. He thinks people make a mistake trying to force an interpretation on an indicator, especially one such as the VIX, which is most reliable at signaling bottoms when it hits extremely high readings of 50 or above.

"People are looking at absolute levels of implied volatility without taking into account that it is still a function of historical price movement," he writes in his report. Right now, historical or actual volatility is below 20%, bringing McMillan to the conclusion "that the VIX currently is not



Breaking the Range

More interesting for McMillan was whether the recent narrow range in which the VIX has traded -- between 21 and 24 from April until last week -- predicts an upcoming move. His research shows that over the past 10 years there have been five other periods with a prolonged, narrow trading range. In each instance, the range was resolved with the VIX moving higher. But it should be noted that in each case the top end of the tight band was below 25, so statistically speaking, it's no surprise it moved to higher levels.

More importantly, how have stock prices responded once the VIX has broken out of its range? Granted, the sample is small, but the accompanying stock-price moves following the VIX breakout shows one small pattern: The dominant direction during the range was renewed and extended four out of the five previous times -- two up, two down, one flat.

Stock prices have never reversed direction after the VIX has broken out of a tight trading range. But the VIX also has never before broken out of a range by moving lower. So, the VIX may in fact be saying nothing other than confirming that volatility is declining to more normal levels after a few years of turmoil.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.