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You Won't Hear This on CNBCBy Jeff ClarkTuesday, October 27, 2009 CNBC is infatuated with the VIX.
The Volatility Index (aka the VIX) is a measure of implied volatility of option premiums. Simply put, it's a measurement of investor fear. If investors are worried about stocks and about the potential for a loss, the VIX rises. As investors get more comfortable holding stocks, the VIX falls.
Last week, CNBC ran dozens of segments on the VIX.
Seriously, by Wednesday or Thursday, it seemed as though every few minutes some talking head on CNBC was spouting off about the VIX making a new low on the year. They viewed this as bullish, since investors were less fearful and, therefore, more inclined to take on risk and buy stocks.
I was looking at something else – the options on the VIX. And those look wildly bearish. Let me explain...
VIX options are different than most stock options in that they're "European" settlement. This means options on the VIX can only be exercised on the option-expiration date – as opposed to "American" style options, which can be exercised anytime. This eliminates the arbitrage potential of buying an option, immediately exercising it, and then unwinding the position for a profit.
So VIX options will routinely trade at a discount to their intrinsic value.
This is why I don't trade VIX options. There's no arbitrage effect and no certainty that an option trading at a discount to intrinsic value will generate a profit.
But I watch the premiums on VIX options because they provide HUGE clues as to where the market will move in the short term.
For example, last Friday, when the VIX was trading at 21, the November 22.50 puts had an intrinsic value of $1.50 – meaning an investor could have bought the VIX for 21 and exercised the right to sell it for $22.50 and pocketed $1.50. That's a guaranteed profit of $50 on each contract under normal circumstances.
The options were trading at $1 – a $0.50 discount to intrinsic value – because the options can't be exercised until the option-expiration date next month. So no one could capture the gain instantly. They'd have to wait and see where the VIX closed on option expiration day in November to determine the profit.
Bear with me, because this is important...
Traders who were buying these options were betting the VIX would be above 21.50 on option-expiration day in November. In other words, even folks who are bearish on the VIX are counting on volatility increasing.
Folks who are bullish on the VIX are particularly bullish. The VIX November 22.50 calls, for example, were trading for $2.50. Traders who were counting on the volatility index rising in value were betting the VIX would be over 25 by option-expiration day in November.
VIX bulls are paying a huge premium for the right to buy VIX at 22.50. And VIX bears are taking a discount to intrinsic value on the puts.
All these traders are betting on an increase in volatility. Increases in volatility are typically associated with declines in the general stock market. So judging by the VIX option market, it's reasonable to expect stocks to come under pressure over the coming days and weeks.
Best regards and good trading,
Jeff Clark
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