Volatility Just Ain’t What it Used to Be

07/19/2012 11:12 am EST


Howard Gold

Founder & President, GoldenEgg Investing

The market still appears extremely worried, but these options experts are pointing to the lukewarm VIX metric to show that contrarian investors could do quite well by the end of this year, writes MoneyShow’s Howard R. Gold, also of The Independent Agenda.

Investors are terrified of volatility. Turn on the television, pick up the paper, log on to the Internet, and you’ll hear about how scared people are of the wild gyrations in stock prices. It’s just one more reason retail investors have abandoned the market like the plague.

The only problem is, it isn’t true.

Sure, the headlines show the Dow Jones Industrial Average gaining and losing hundreds of points at a clip. But on a percentage basis, that’s not very much.

And the ups and downs this year are actually smaller than in years past. For all the hand-wringing about Europe or a new recession or the US “fiscal cliff” over the past couple of months, the S&P 500 is only 3% off its April 2 high of 1,419.04. And it fell only 10% from that peak to its June 1 low of 1,278.04.

But the clearest evidence comes from the volatility index itself, the VIX. The VIX is the Chicago Board Options Exchange Volatility index, which measures the implied volatility of options on the S&P 500. It indicates how volatile traders expect the market to be over the next 30 days.

High VIX readings mean investors and traders expect sharp moves in the S&P either way; lower numbers mean market participants anticipate relatively calm seas.

The VIX hit an all-time high near 90 on October 24, 2008, in the midst of the financial crisis. It closed Wednesday just below 16.5.

In fact, the VIX has been dropping since the financial crisis: It peaked just below 50 around the time of the “flash crash” of May 2010 and when the market bottomed in August 2011, and hasn’t gotten above 27 during the current sell-off.

Ryan Detrick, senior technical strategist for Schaeffer’s Investment Research, a Cincinnati, Ohio-based firm that specializes in options, says the VIX has been moving lower because of an excess of caution by the hedge funds and big traders who dominate the market.

The so-called smart money is hedged heavily against a big surge in volatility, he explained. “VIX call open-interest recently reached a record 4.64 million contracts at June expiration, which was about 10% above the previous all-time call open-interest in March, April, and May,” he wrote in an e-mail.

“So many people are hedged that we don’t see the VIX spiking higher,” he told me.

The firm’s chairman and CEO, Bernie Schaeffer, wrote in the June issue of the Option Advisor newsletter: "The US stock market has been behaving, both in terms of price and volatility, in a rather orderly manner in recent months…While in 2012, [14-week historical volatility] has been steadily rising from its low of 11% in March, it is currently just below 17%— less than half its peak of last summer and about one-fifth of its financial crisis peak.”

NEXT: Investors and Traders Absorb the Bad News


What’s happening? Little by little, investors and traders are digesting the bad news about Europe and the global economy.

“There is some calming effect—we’ve had these European issues for 2 1/2 years,” said Detrick. “These are chronic issues. People are slowly realizing those issues are still there, but there won’t be another 50% bear market.”

In other words, Europe is suffering from cancer rather than a heart attack. When the disease flares up, the continent gets a dose of chemotherapy and everyone moves on. That’s how market pros see it, too, The Wall Street Journal recently reported.

Investors, the Journal wrote, are “turning down the volume” on Europe. “’The signs are everywhere that many market participants are tuning out,’” one pro told the Journal.

That’s why the VIX “has tumbled almost 40% since June 1 and is nearing its lowest levels since early 2010.”

One gigantic difference between now and the worst days of the financial crisis: Back then, nobody expected Lehman Brothers to fail. Now, everyone anticipates some big restructuring of the debt of Greece, Spain, and Italy sooner or later, so the element of surprise is missing.

Detrick’s conclusion: “We definitely think [we’ll see] more normalcy, Europe isn’t the end of the world, [and] maybe we’ll see a more normal VIX like in the 2000s—12 to 18.”

That could mean a big election-year rally, which Detrick believes may have started already. He thinks we saw the low in the S&P in April, and Schaeffer’s Investment Research has a target of 1,525 by the end of the year.

Options maven Lawrence McMillan, president of McMillan Analysis, sees similar risk aversion in the market. “Definitely I feel people are overly worried, which is…bullish,” he said.

And he likes the trend in the VIX. “A descending VIX is bullish,” he told me. “As long as the VIX is below 21, the market is not worried and can go higher.”

He sees support for the S&P around 1,330 to 1,340, and “our intermediate target is 1,440—we’ll reassess when we get there,” he said.

So, for these two options experts, volatility isn’t a problem at all. The fact that so many others still think it is may offer an opportunity for investors who are willing to go against the crowd.

Howard R. Gold is editor at large at MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and read his coverage of the 2012 presidential election at www.independentagenda.com.

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