Volatility Not a One-Way Street

07/09/2009 2:32 pm EST

Focus: OPTIONS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, likes State Street puts as a hedge against excessive short-term optimism. 

Some musings on volatility and the CBOE Market Volatility Index (VIX).

You can’t refer to volatility without defining your time horizon. The 10-month historical volatility of the S&P 500 Index (SPX) is currently at 49%, its highest level in modern times. But the 10-day historical volatility of the S&P is just 22% and has retreated in recent months to its lowest levels since mid-2008.

Is the market currently volatile? Looking at long-term volatility, the answer is an unequivocal “yes.” But short-term volatility is only modestly above that of the bull market days of 2007. And intraday volatility has been almost non-existent in recent weeks. There have been numerous intraday periods during which minute-to-minute volatility has retreated below 10% (and even below 5%) for hours at a time.

Equity volatility is seasonal. According to a recent study by Larry McMillan: “There is also a seasonality to VIX trading patterns… You can see several patterns (over the past 20 years). Early in the year, there is typically a small peak in VIX in January, followed by a slightly higher one in March. Then it goes into a decline during the spring and into mid-summer. It probably comes as a surprise to no one that the low in volatility occurs around July 1st of each year. What might come as a surprise though is that volatility typically rises quite a bit during July and August. Then it really gets going in the fall—in September and October, when the stock market typically has major declines. It peaks in October. After that, volatility becomes surprisingly docile for the rest of year, until by Christmas it is almost back at the July lows. Not every year follows the pattern exactly, but most are a reasonable approximation. 2008 followed quite closely, and this year the pattern is typical as well.” So is it time to assume that the VIX will rally according to these past seasonal patterns? Perhaps, but I’d also suggest the possibility, based in part on the ongoing compression of historical volatility, that the VIX might continue to decline to surprisingly low levels—perhaps as low as 20—before it bottoms.

State Street (NYSE: STT)—ExpectationAnalysis®: The shares of STT have been fighting a losing battle on the charts, thanks to resistance at their 60-week moving average. This defiant trendline has capped the stock’s rally attempts during the past month, and hasn’t been conquered on a weekly closing basis since May 2008. Nevertheless, Wall Street remains optimistic toward the equity, as STT harbors six “buy” or better ratings, compared to five lukewarm “holds” and a lone “sell.” Plus, option traders on the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) are flocking to the bullpen, too. During the past couple of weeks, speculators on these exchanges have bought to open more STT calls than puts, as indicated by its 10-day ISE/CBOE call/put volume ratio of 1.39, in the 74th annual percentile. STT’s poor price action could spark an unwinding of optimism, adding to the stock’s technical troubles.

Recommendation: Buy the November 55 put (SPJWK).

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