One of the things that truly drives the big indexes in both trading and in changes in implied volatility is, perceptions of fear. The thing about stock market fear is that it does not hit when the market is at its absolute lows. If we look back at the meltdown of 2008, the CBOE Volatility Index (VIX) hit its peak in November of 2008, and then began tailing off.

By the time the market had hit its lows in March 2008, the VIX was trading 35 percentage points lower than its peak. What caused this difference? My belief is, in November the market was selling off, but no one understood how bad things could get. There were some people forecasting the end of privatized banking. While it certainly seems silly now, think back to November, and tell me that you were not at least a little worried about the financial world coming to an end. Once traders realized that the world was not going to come to an end, only that the stock market was overpriced, implied volatilities fell with the stock market.

We may be seeing a similar pattern over the last four months from the S&P 500 Index (SPX). The VIX peaked on May 20 $45.00. Low if one looks back at 2008, but actually quite high over the history of the VIX. I remember trading on the floor in 2006 and seeing the VIX below the teens, and even below 10 at one point. On May 20, SPX closed at 1071, well over 10% off the market highs. Since May 20, which is the high on the VIX, the SPX has hit bottoms lower than 1071 on three separate occasions. On each of these occasions, the VIX has had lower highs, followed by lower lows.

CBOE Volatility (VIX) Four Month
Source: TD Ameritrade

S&P 500 (SPX) Four Month
Source: TD Ameritrade

In the chart above, you can see on July 2, the actual market low since the "flash crash" when the the VIX peaked out at less than $32.00. On the next dip, the one we are currently experiencing, the VIX has not even been able to break $30.00 We hit our lows (as of the writing of this piece) on Aug 26, and the VIX closed at $27.37. Jimmy Carter had the misery index. If there was a trader's misery index, this might be its peak. The market is falling, which is bad for the longs, and volatility is falling, which is bad for both the premium sellers and premium buyers. Basically, the only real way to have one is, to be right that the market is falling, and even then the trader may have lost because of implied volatility falling.

So, how do traders make money in this trader's misery index? It certainly is not easy. It involves finding a good trade in a bad situation. Based on the pattern we are seeing, the only thing I can conclude is, the VIX is going to continue to fall, even as the market oscillates slowly downward.

Personally, I am not in love with VIX options themselves, because it is difficult to quote the futures on many trade systems (sadly, there are some that do not understand the options are priced off the futures). I think we are heading for more market movement, with more implied volatility falling. The only way to win in this market is to be short vega, and either long gamma or right on direction.

For the institutional guys I would be keeping an eye on the time spreads in the SPX, NDX, RUT and OEX (all indexes). When they get out of whack, I would be ready and willing to sell,or buy them. For retail traders, looking at patterns in the VIX, I do not see implied heading much further, without some sort of major change in economic numbers. I would be looking to sell put spreads in SPDR S&P 500 ETF (SPY - Get Report), PowerShares QQQ Trust (QQQQ), iShares Russell 2000 Index ETF (IWM - Get Report) or maybe the MNX (Mini-Nasdaq: 1/10th the value of the Nasdaq-100 Index). Personally I am a fan of SPY.

Trades: Sell to open the SPY Oct 106 puts at $3.92, buy to open the Oct 104 Puts for $3.14.

Net: Sell the 106/104 Put Spread at $0.78.

At the time of publication, Mark Sebastian held no positions in the stocks or issues mentioned.

Mark is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange, and is currently the Director of Education at The and the Director of Risk Management for a private hedge fund. Mark also writes, a popular index and equity options blog.

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