The market continues to tick lower in the new year, but a volatility measure of options activity suggests that speculators aren't yet panicked about a larger falloff."The market has moved a lot and you would think that there would be some worry out there, but there is none," said Bob Wilson, chief options strategist at Susquehanna Financial Group. "If you knew your house was going to burn down and someone offered you insurance, you'd buy it. No one is out there buying protection right now." That measure of insurance is the Chicago Board Options Exchange Volatility Index, (VIX) which tracks expected near-term volatility based on trading in index options on the S&P 500. Its recent drop to multiyear lows, which are used by speculators as contrarian sell triggers, has led some to worry that a larger decline in stocks is imminent. The negative start in the stock market in 2005, which has caught investors by surprise, has added fuel to that concern. The S&P 500 dropped in five of its first eight trading sessions, shedding 2% in the process. Historically, more people buy options during periods of market declines. This, in turn, boosts options prices, and increased options trading drives the VIX higher. Demand for options, especially puts, increases as stock prices fall -- a declining stock market is seen as riskier than a rising market. Options can offset the risk by hedging a portfolio and can even reap a profit from a declining market. Conversely, options demand -- and prices -- traditionally decline as the stock market increases, pushing the VIX lower. But many investors use extreme levels in the VIX as contrarian indicators of market tops and bottoms. In 1998, high VIX levels caused by a frenzy of fear surrounding the collapse of Long Term Capital Management and the Russian debt debacle successfully pegged a trough in stocks.
And when the VIX fell to a two-year low in March 2002, investors would have done well to sell, as the S&P 500 fell for the next four months. Throughout the run-up in stocks at the end of 2004, the VIX worked its way lower, sliding to a nine-year low of 11.23 on Dec. 23. (Since then, the VIX bounced to 14 to close the year, but has subsequently retreated.) Such a low level has been used by contrarians to indicate high complacency in the market, which in turn can lead to a halt in stock purchasing and, thus, an imbalance that breeds broader selling. But many investors aren't yet seeing that complacency. "The natural move
in the VIX right now is down -- it's the path of least resistance," said Susquehanna's Wilson. "It just doesn't appear that there are buyers of options out there. If there were, you would see it in the VIX." This is despite the fact that the VIX is well below 20, which has typically been considered a trigger to sell stocks. A VIX level above 40 -- traditionally suggesting a high level of pessimism -- has been pegged by contrarians as a time to buy stocks. However, Sam Olesky, principal of Olesky Capital Management in Mill Valley, Calif., sees the longer-term trend in the VIX merely reverting to the lower levels that it logged in the mid-1990s. A lower VIX represents a rational return to reduced volatility levels, he said. Trends bear this out. From 1991 to 1995, the VIX ended each year between 11.5 and 20. From 1996 to 2002, the heart of the bull market and the subsequent burst bubble, the VIX closed each year between 20 and 29. For the past two years, however, the VIX has worked its way back down to the levels of the early 1990s. The VIX hasn't traded above 20 for any substantial amount of time since September 2003; this is also the last time that the VIX approached 25, let alone 40.
Still others think the VIX may have less relevancy than it did in the past. "People hedge their portfolios differently than they used to," said Scott Curtis, managing director of trading at Kinetics, a New York-based money management firm. He said the proliferation of exchange-traded funds, like the SPDR Trust ( SPY) on the S&P 500, has allowed traders to quickly and easily short baskets of stocks. "People look at the VIX with the same glasses as they used to, but participants aren't participating as they used to," Curtis said. "A lot of players are playing
ETFs instead -- it's more efficient, you're not paying for time value, and many ETFs are much more liquid than options."