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Volatility Update: Fear Gauge Taps on the Brakes

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March 24, 2016
Volatility Update: Fear Gauge Taps on the Brakes

The roller coaster ride continues after the S&P 500 rebounded sharply from its February 11 lows and has now tiptoed back into positive territory for 2016. A sharp decline in volatility accompanied the nearly 12% rally in the S&P 500, and it’s not just the CBOE Volatility Index (VIX) that is moving lower. The decline is showing up across many asset classes, and in some measures of real volatility as well.

Volatility Crush

The recent free fall in VIX is not unprecedented. In fact, from August 24, 2015, through October 23, 2015, the market’s “fear gauge” dove from 40.74 to 14.46. That’s 64.5% in two months!

The recent decline has not been as dramatic so far, but is still a sizable move for the index. To be specific, since February 11, the VIX has dropped from more than 28.14 to 14.44 (through March 17). That means VIX has been cut nearly in half in a little more than a month (see figure 1).

CBOE Volatility Index

FIGURE 1: VOLATILITY CRUSH CONTINUES.

The sharp decline in VIX is shaping up like the one from last August to October. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Yet, it’s not just the CBOE Volatility Index that’s moving lower. The table below shows the decline in other VIX-like indexes since February 11 (through last Thursday). VIX tracks the expected or implied volatility of short-term options on the S&P 500. Volatility in the Dow Jones Industrial Average, as measured by the VXD, is down more than 50%. Volatility for the NASDAQ 100 (VXN) and the Russell 2000 (RVX) are down sharply as well.

What about outside the equities markets? I thought you might ask. Oil implied volatility (OVX) is down more than 40% and volatility of gold (GVZ) is down 33%. Emerging markets volatility (VXEEM) and China volatility (VXFXI) are both down nearly 40%. And even in the currency markets, the volatility of the euro against the dollar is easing, and EVZ is down more than 30%.

Vol Crush
S&P 500 Volatility VIX -48.7%
NASDAQ 100 Volatility VXN -43.7%
Dow Volatility VXD -50.4%
Russell Small-Cap Volatility RVX -41.7%
Oil Volatility OVX -40.6%
Gold Volatility GVZ -33.1%
Emerging Markets Volatility VXEEM -38.8%
Brazil Volatility VXEWZ -1.6%
Euro Currency Volatility EVZ -30.6%
China Volatility VXFXI -39.6%

% change, 2/11/2016 to 3/17/2016. Data Source: CBOE.

This Is Real

One reason for the decline in VIX and other VIX-like indexes is a drop in actual or realized market volatility. Because VIX is computed using an options pricing model and is based on options premiums, it doesn’t just reflect the actual volatility of the equities market in the past; it also represents what market participants envisage in terms of future volatility.

To strictly measure realized or actual volatility requires a different measure. For example, a 20-day historical volatility, like the one plotted in figure 2, is computed using only closing prices over the past 20 days. Expressed as a percentage, it is the annualized standard deviation of prices over the previous 20 trading sessions. Like the VIX, 20-day HV is approaching 14 and is down sharply from the readings north of 23 seen in early February.

S&P historical volatility

FIGURE 2: S&P 500 DAILY CHART.

Actual or historical volatility, such as the 20-day HV of the S&P 500, has been falling sharply, just like the VIX. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

In conclusion: not only have risk perceptions been down sharply in recent weeks, but actual levels of market volatility have been declining as well. The equities market is making smaller moves from one day to the next, and that, along with the bullish trend, has led to a nearly 50% decline in VIX. Other volatility indexes are also down sharply. So it seems that the latest volatility drop is part of a larger, powerful theme across global equities, commodities, and currency markets. 

RED Option Strategy of the Week

Tom White, RED Option

Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

Volatility has dropped like a stone over the last few weeks as stocks have plowed to 2016 highs. A dovish Fed and rotation into riskier assets such as equities has supported the rise in markets. Option premium is getting sucked out of the market as uncertainty wanes. This drives the price of options significantly lower and provides options traders potential opportunities to purchase protection or take some speculative directional moves.

There are times when you may surmise that a big move in a stock may be warranted. The major problem is that you don’t know which direction a stock might move due to the plethora of news and data that exists. Wouldn’t it be helpful if you could initiate a strategy that could profit from such a move whether the underlying was up or down?

Long straddles are a strategy designed to take care of this assumption. The initial cost of the position can be low when option premium is low as volatility falls. The strategy profits from increased volatility and moves in the underlying. It involves buying both calls and puts on the same underlying asset. The strike is same on the purchase of both calls and puts in the same expiration cycle and is typically done on at-the-money strikes. The idea is that a trader might profit if the underlying significantly increases or decreases, such that the call or put can be sold for more than the cost to purchase the two positions. 

Straddles seek to profit from significant moves up or down in the underlying. A rise in volatility will also increase the value of a straddle. Because you are paying for two options, buying time decay or theta on both sides, the stock usually has to move considerably to produce profits. Initiating the strategy simply involves buying a put and call with an expiration that gives the underlying enough time to move significantly, and straddle buyers are best served by not holding positions as expiration gets close, as that is when time decay (theta) is greatest. When is a good time to buy option straddles, you ask? This might be when volatility is low and there may be a catalyst like news on the underlying or in the overall market.

The maximum risk is the debit paid for the options. If the implied volatility drops, the position can also lose value, even if the underlying moves. This is why buying straddles before earnings (or other news) can be a risky strategy. Even if the stock moves, the drop in implied volatility that often happens after earnings are released can more than offset the gain from the move in the underlying.

The long straddle is risk-defined, which means you can’t lose more than what you paid (including transaction costs), but be aware that a significant move is needed to profit!

Straddles and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

Free: 2 Strategies for 2 Months*

Get step-by-step TradeWise trade ideas from former floor traders delivered directly to your inbox. At checkout, enter coupon code “ticker”. 

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