No Fear & Loathing in the Options Market

10/22/2012 7:00 am EST

Focus: OPTIONS

Mark Sebastian

Founder, OptionPit.com

According to a recent article in The Wall Street Journal, investors are snapping up VIX call options in record numbers in anticipation of a rise in the “fear index” due to the election, continuing Eurozone saga, and the fiscal cliff. Options trader Mark Sebastian offers a couple of plays, depending on your view.

I have been commenting for some time on why I do not see a sell-off on the horizon. I see a fully hedged market place right now. But what does a fully hedged market look like? It looks like this:

Take a look at realized volatility on 10- and 20-day historical volatility.

chart
Livevol® www.livevol.com
Click to Enlarge

HV is currently at 7.9%; this is in the toilet low. In fact, when the VIX was near 14, HV was actually higher than it currently is now. The VIX is trading between 15 and 16, double the value of realized volatility.

chart
Livevol® www.livevol.com
Click to Enlarge

Why is HV lower than it was when the VIX was 14 or when the VIX is near 16? The reason, a fully hedged market. Traders are holding lots of collars and puts against generally long positions. This, as we stated last week, is going to make sell-offs very tough.

But, you say, I think we are going to have some trouble next spring. I go out and buy long-term VIX futures....Bad idea.

chart
www.vixcentral.com
Click to Enlarge

For how overpriced the VIX cash is, the long-term futures are even worse. I think the VIX is expensive at 100% of HV. However, with May trading near 24, long-term vol is about 200% of realized volatility. Long-term futures look like such a bad idea in the near- and long-term.

The Trade
If you think the VIX is going up, with the skew steep in SPX, I would be looking to own put spreads. However, we think there is a rally coming with a drop in vol. This is a great set up for butterflies and put spreads.

By Mark Sebastian of OptionPit.com.

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