With the VIX around 15 and drifting lower on alot of recent days as the market makes new highs it seems a good time to discuss option premium and low vol environments.
The first thing to know is the way volatility works in general. Volatility in the markets is a bit like playing doubles tennis at the net, long periods of boredom as you watch other people hit the ball back and forth, occasionally broken up by having to react to the ball nearly hitting you in the face.
Have a look at the historical chart:
You’ve probably heard here and some other places that the historical mean in the VIX is in the 19-20 range, which is true, but from a numerical and percentage standpoint it doesn’t go much below that level. Lows rarely stay in the low teens, and low vol environments tend to bounce between the low teens and its historical mean. Spikes to the upside go really high on a numerical and percentage basis and sometimes, like during the ’08 Financial Crisis, go parabolic and rip your face off.
So when you see the VIX at 15 like it is now, just buy premium and wait it out right? In a word, no. And it explains why the above chart looks the way it does.
The VIX gets killed after high vol periods, like what we just saw with worries about European sovereign debt, because people are generally exhausted, but more importantly people are loaded up with option premium from higher levels and are now choking on it.
If you look at the VIX chart of the past year you’ll see the craziness of last fall followed by a steadily declining index marked by lower highs and lower lows. This is the result of a few things, an advancing market, less worries out of Europe, but also what long premium does to you in a vol crush.
On a vol spike, options traders will get short premium and try to ride it out. If they have enough money in the bank and can survive the swings in deltas produced by their short gamma they stand to make alot of money when the market calms down and volatility subsides. On the flip side, when volatility is getting crushed, traders are both long vega that they’re losing money on, and they’re losing a ton of money on decay. Because these times of low vol are almost impossible to ride out, because they tend to last for so much longer, it often becomes a situation of dumping premium at any price to avoid the pain. This has a snowball effect and is the reason you see the lower highs on spikes and lower lows on crushes.
Going back the first chart, clearly the mid 90’s were the longest lows. I remember when I first started trading in the late 90’s having to listen to war stories from the old timers on the floor about how miserable those years were for options traders. In the late 90’s things got so out of hand, as the Nasdaq bubble inflated to 5000, that the market actually saw a rising VIX alongside a rising market. This is very rare and something I mentioned was happening in AAPL recently.
The VIX also had a long run along its lows during the recovery in the mid 2000’s from the tech bubble. This ended when everyone realized the banks had loaned about a trillion times more dollars than they should have, and we saw a VIX spike to epically high levels when the market came crashing down.
Are we about to enter one of these long periods of low vol? It’s impossible to say until afterwards obviously, but I kind of doubt we’re in for a multi-year run like the 90’s and 2000’s. But barring a one off event like we saw with the Japanese tsunami or Greece defaulting, this could certainly last for months if not the rest of the year. The reason is as I stated above, low vol has a certain snowball effect.
To take advantage of this you have to reset your upper limits on what’s “high in the VIX.” Barring a reason for the market to have a serious selloff, the upper limit in the VIX becomes the high teens and low 20’s. Your position management should reflect that. A correction of 5-10% in the market probably isn’t enough to see the VIX at 30 in this environment. That would require a bit of a black swan, like Europe coming back into news or an oil shock.
But remember, these things do happen. And they seem like they happen more and more frequently as the world becomes more intertwined and trading becomes more interconnected. So stay on your feet and be careful of having a portfolio loaded with long premium in a low vol environment, be quick to take profits on vol spikes. But don’t do anything crazy like selling VIX 25 calls in September because anything can happen.
(Post title from 24 Hour Party People. If you got it great. If you didn’t, that’s fine too. But you should probably watch more movies.)