Enjoy Low Volatility…If It Lasts

04/26/2011 3:21 pm EST

Focus: OPTIONS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Options expert Larry McMillan discusses the two-year decline in the volatility index (VIX) and what option traders should learn from the low readings while—or if—they last.

How low can volatility go? Let’s ask Larry McMillan. Larry, we’ve got low volatility, what can we do?

Well basically, I guess, enjoy it; it means the market is going up. There’s…you know, people watch the VIX, the CBOE Volatility Index, and they get concerned about different things. 

One thing you hear now, “Well, VIX has stopped going down, yet the market is still going up, so what does that mean?” I don’t think you should read anything too significant into that. 

Ideally, yes, they would trend opposite at all times, but really, as long as VIX is staying subdued, even if it’s kind of going sideways, I don’t think that’s a problem for the market. 

Now if VIX were to start to jump up, then you might have some problems. What’s really happening I think is that a lot of traders are long stocks, and you get a little nervous because the rally has been going on for so long.  Like you said, it’s two years and doubled, or even since last August, we’re up 27%.

They’re starting to buy some SPX puts for protection. When they do that, it elevates VIX, because the price you pay for those SPX puts raises their implied volatility, which raises VIX. 

That’s really kind of what’s keeping VIX where it is, keeping it from going down. In 2006, it did go all the way down to 10, and that’s really not much fun for volatility traders. I guess that could happen, I’m not writing that off. 

As far as VIX being low, it does mean that protection is relatively cheap, and as I had said before, I like buying VIX calls rather than SPX puts. 

Volatility is a relative thing. The historic volatility right now, the actual volatility of the S&P 500 is running around 10%, so with VIX, that’s 16%; that’s not a huge differential. I wouldn’t say that VIX is either expensive or cheap when you look at those two figures together.

Which also might say then that the underlying market is fairly priced as well, even though it’s on this incredible tear.

Right, exactly, and eventually, volatility will go up. It oscillates, it always has. It goes low, stays there for a while, and then spikes up somehow eventually.

There’s an old saying that VIX makes rounded bottoms and spiked tops, and the market does the opposite.  We’re in…yeah, we might be in a topping process, but there’s really no pure evidence of it at this point.

So, just as an insurance then, buying the VIX.

Exactly, exactly.

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