Mark:

With coordinated efforts of many of the world central banks to loosen credit,let's to take a look at how the volatility markets are reacting to the rally. While many might expect to see the

CBOE Volatility Index

®

(VIX)

and VIX futures getting crushed, VIX is holding up. Why? I asked Russell Rhoads from the CBOE's Options Institute and our co-host on Saturday to join me in discussing some possible reasons for strength in the VIX today.

Russell: Although the VIX has been tagged an index of fear or greed in the stock market, it does quantify something that is very important to institutional investors. It can be considered a measure of whether the cost of portfolio protection is high or low. The VIX is a measure of implied volatility as priced by S&P 500 Index option contracts. All else being the same the higher the price of an option contract, the higher the implied volatility as indicated by that price. When the implied volatility of S&P 500 index options is high the result is an elevated level for the VIX index.

Excluding the price action today, the VIX has closed above 30 on 72 of the last 80 trading days. There have been eighty trading days since August 8 when the market dropped over 6%. To give the casual VIX observer some perspective the CBOE has historical VIX data from January 1, 1990. From that date to the last day in 2007 the VIX was above 30 only 6% of trading days. Needless to say, 30 is a pretty high level for the VIX and the result is expensive portfolio protection.

Even before today's action there was much discussion of the VIX remaining at elevated levels. So why has the VIX stayed at this level over the past few weeks and remains closer to 30 than 20 today with the overall stock market screaming higher? One thought is that even with the market acting strong today, there are a number of potential negative events that may still negatively impact the stock market on the horizon. Each day when we wake up and check our favorite business network we never know what new news is going to come out that will impact our markets. This sort of concern has portfolio managers seeking portfolio protection.

The VIX not dropping related to the rally in today's stock market indicates there is still demand for S&P 500 Index options, specifically puts for portfolio protection. To put this in the context of buying stock, it appears those seeking protection against a drop in the stock market may be using today to buy this protection at a little cheaper prices than the cost yesterday. Those seeking portfolio insurance have been itching to buy puts, but hesitant with the VIX above 30. The move below 30 has brought enough option buyers into the market to cushion the drop in the S&P 500. Another interesting index that the CBOE publishes is the CBOE S&P 500 Skew Index or SKEW. The SKEW quantifies the implied volatility of out of the money S&P 500 Index option contacts versus options that have strikes closer to the current market. If the implied volatility of farther out of the money options is equal to options with a strike price closer to the market the SKEW would be quoted at 100.00. The higher the SKEW the more demand for portfolio protection against a large drop in the overall market.

The SKEW is calculated on the close each day and has remained at a relatively normal level over the past few weeks closing at 116.45 yesterday. The historical range for the SKEW this year has been a low of 113 and a high of 136. Yesterday's close put the cost of out of the money protection at a low relative level in 2011. This is also interesting as it indicates although there is concern about the overall market as indicated by the elevated VIX, there has not been increased demand for out of the money option contracts to protect against a big market drop. Possibly another indication that those seeking protection have been waiting on the sidelines for a day like today where options have gotten a little cheaper.

Mark: While the VIX certainly represents fear and the cost of insurance, at its core the VIX is a measure of volatility. Last week, as the market touched recent lows, many (myself included) were lamenting at the VIX's tepid reaction to the selloff. There were good reasons, looking back for a lack of reaction, primarily the rate at which the market sold off from 1257 down to 1158.

It took about seven trading days to move about 100 points. Under normal circumstances, this would be some crazy movement. But as Russell pointed out, this is not a normal time, the VIX has been above 30 on 72 of the last 80 days. In order to justify a VIX over 30%, the market needs to move about 2% a day. From November 16 on, the market did not move at that pace. While volatility normally sees a VIX increase in a down market, we did not. In fact, REALIZED volatility, sometimes called historical volatility actually FELL as the market was bottoming out hitting an absolute low on November 25 (the bottom of the market).

Looking at this week, we have seen a huge change in REALIZED volatility, what took seven down trading days to accomplish has been wiped clean in less than three trading days. The market has moved more than 3% in two out of the last three days. Even if one believes that the world is a safe place for investors now (it isn't), how could VIX, a measure of market volatility truly fall while the S&P 500 is gapping up more than 3% two out of the last three days. Realized volatility is high, thus implied volatility must stay elevated as well. VIX, swap markets, S&P options, VIX futures...any volatility related product is going to remain high. In order to really see the VIX below 30 to stay we are going to need the following:

1. An extended rally

2. Less systemic news

3. Smaller overnight price movement in the major indexes

4. Smaller intraday price movement in the major indexes

Until the indexes stock flying up and down, the VIX is going to be historically high. This is why I would contend that while it may seem counter intuitive, it would be better for the market to be up 15 points tomorrow than 50. Large price moves, up or down, are indicative of a tense market which will produce an elevated VIX.

In the end volatility markets are not elevated today because of insurance buying or high market realized volatility. They are elevated because of both.

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At the time of publication, Mark Sebastian and Russell Rhoads held positions in VIX.