It’s an Option Seller’s Market

10/31/2011 10:25 am EST

Focus: OPTIONS

Mark Sebastian

Founder, OptionPit.com

The extreme market volatility seen in recent weeks has since subsided, but uncertainty remains. Until a clearer sign emerges that buying options is prudent, option sellers may find the best opportunities.

When the world is waiting for a big bang, it seldom gets it. For the last three months or so, the financial markets have been pricing Armageddon into every nook and cranny they could find as we all waited for the big one. Well, it has not happened yet.

The key turnaround was in early October, when the market was going through fatigue. Volatility markets were pricing at levels for a collapse that never happened, and the slow, steady decline in volatility started to gather steam like a rock rolling downhill.

That was the beginning of the end for extreme volatility, as the Eurozone started to make the right kind of noise. With a 45 VIX, no one cares about equity fundamentals, earnings, or bulk shipping rates.

Now, with a VIX settling around 24.6 and getting close to a 50% decline from the highs this month, maybe some of the equity fundamentals come back into vogue. The earnings cycle is going to start to matter as the details of the trillion-dollar Euro bailout begins to percolate downward through the markets.

But have the implied volatilities in stocks really gotten down to the rock-bottom levels where buying options makes sense again? Let’s take a look at the bellwether name, Amazon.com (AMZN).

chart
Click to Enlarge

AMZN earnings came out and there was disappointment. There was a solid slide, and for the most part, it has retraced to pre-earnings levels. But what’s more interesting are the relative levels in implied volatility before the August crash and now.

If you look at the chart above, the new lower levels (around 40% in implied volatility, or IVX) in late October would have been a near top anytime during the first eight months of the year. The near-term low would have been close to the high tick this year, ex Euro mess. Lots of volatility charts look like this.

The question now is really whether we break down to more “normal” levels, or does the market experience the “fatigue” of early October, albeit at lower levels? For traders who are more willing to sell options, this might be a great opportunity in select names. Let’s see what happens.

By Mark Sebastian of OptionPit.com

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