How Options Can Tell Us When This Rally Will End

10/01/2010 12:01 am EST

Focus: OPTIONS

Steven Place

Founder, InvestingWithOptions.com

With the strong rally in the equities market off the 1040 level, many are looking to the options market to get a little insight on whether this rally will last. And the conclusions one draws generally will confirm their pre-existing bias. However, I think the action in the VIX and VIX futures have been providing a very interesting narrative over the past few months.

Remember, the VIX is a statistic measuring the supply and demand of SPX options—it is not tradable directly, of course, (options and futures are available), so your basic technical analysis will tell you little about it. It requires some nuance in understanding this specific set of tealeaves.


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The Flash Crash

There had been a significant overhead level around the 30 line in the VIX before the flash crash. Once the market structure failed on May 6, we saw a sustained bid for S&P premium as funds and large players rushed to protect themselves out of fear that the flash crash would lead to something worse. Over the course of the early summer, we continued to see an elevated range being put in as there was still an overhang of fear in this market.

A Drop in Demand Leads to…

But the VIX was continuing to make lower highs. This makes sense: The traders who bought puts and other protection a week ago don’t need to buy it again, so you see this drop in demand for S&P premium. We’ve essentially seen these lower highs continue to drop, and we are now between the support level and the trend of less premium demand.

Putting It All Together

How does this relate to the market rally? I think Scott Bleier of CreateCapital has laid out the best thesis: The market is rallying in part because way too many people are protected and fully hedged right now. Once all that premium burns off, it may be a different story. While it is not apparent now, there had been a constant level of fear since the 1040 retest.

Remember when everyone said how September was going to be a terrible month and the VIX futures were pointing in that direction? Well, the option guys got it wrong—they weren’t the smart money, in this case. We are still seeing that effect in the VIX futures, with an elevated curve a few months out as traders are still expecting more volatility going into the fall. They may turn out to be right, but they may not make money.

By Steven Place, option trader and blogger, InvestingWithOptions.com

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