Are VIX Option Traders “Smart Money”?

Volatility has been getting crushed lately. As Bill pointed out a few days ago, the historical volatility for the S&P 500 index hit a 39 year low. And once again this is inspiring many to point to it as a sign of a market top. This market myth is proving really difficult to kill but I’ve tried my best.

The latest attempt was just before the holidays late last year: Recent Low Volatility Isn’t Necessarily Bearish.

So imagine my surprise when I read recently in Barron’s Strike Price column that the ‘smart money’ VIX option traders were betting big on a sharp rise in volatility:

Sophisticated investors are actively buying call options on the Chicago Board Options Exchange’s Volatility Index (VIX) that would likely increase in value if the Standard & Poor’s 500 index falls sharply by the middle of February.

These VIX call options will pay off if the VIX spikes to 27.50 in February from its current level of about 18. Such dire expectations are sharply at odds with bullish reports from major banks and news organizations detailing why the stock market will rise sharply in 2011.

The bearish posturing in VIX is ample evidence that some investors have not forgotten that the stock market never advances in a straight line, and never misses an opportunity to hurt the most people, most of the time.

On December 22nd the VIX fell to 15.65, the lowest level since April 2010 when the market reached an intermediate top. It was within a few days that the 10 day moving average of the VIX put call ratio fell to just 0.38 – put another way, in the past two trading weeks, there was 263 VIX calls traded for every 100 puts traded.

That is a very high level of bullishness for the VIX. But does it prophesy that the VIX will spike up and the stock market fall?

I’m not so sure. First of all, there is scant evidence that a low VIX is indicative of a market top. Second of all, looking at the relationship between the put call ratio of the CBOE Volatility index and the index itself, there is hardly any evidence that they are in any way correlated:

I’ve pointed out a few low points in the put call ratio in the above chart. And as you can see, there is no discernible relationship. As well, the earlier data is simply bizarre. But there is probably a good explanation for this.

Unlike the equity put call ratio, this put call ratio is very new. Call and put options began trading on the VIX in early 2006. And from 2006 to about 2008 this new derivative had little volume so it was naturally more susceptible to wild swings. As more and more traders entered the VIX options market, liquidity and total volume increased, providing more representational data:

If anyone is interested in doing their own analysis, drop me a comment and I’ll be happy to send you the files – as long as you pinky promise come back and share with us your findings.

Single Stock Volatility Indexes
Speaking of new derivatives, this Friday, the CBOE will be introducing single stock volatility indexes and plans on adding options on them at a later time. For now only 4 large capitalization stocks have been selected for the honor: Goldman Sachs (GS), Amazon.com (AMZN), International Business Machines (IBM), and Google(GOOG).

The list will grow as volume comes into this new breed of derivatives. And initially the indexes will not have any derivative tied to them but simply be calculated and disseminated.

So very soon we will be talking about an individual stock’s ‘fear gauge’ and what it means. Of course, we’ll have to be patient and wait a while for the data to drip in so that we can analyze it. Hopefully it will provide more insight than the VIX’s put call ratio.

But again, maybe someone out there can attack the data with a fresh perspective and glean something more insightful out of it. I’m always left in awe of the calibre of my readers.

Personally I’m more looking forward to the introduction of the CBOE S&P 500 Skew index which is intended to “measure the tail risk of S&P 500 returns and represents the price of a tradable exposure to this risk”. This will be coming out a little later towards the end of the month.

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4 Responses to Are VIX Option Traders “Smart Money”?

  1. Jim says:

    Nice post, babak. It’s amazing how much of what is claimed as market knowledge has no factual basis.

    I’m looking forward to the sentiment overview this week to hear your take on the equity ISE – there were some pretty high numbers even on declining market days.

  2. graeme says:

    Surprised there’s not been any comments! I’d be more than happy to share any findings on this in exchange for the data, though it’ll probably take me a few days to get through it all and report back any findings.

    Cheers

    Graeme

  3. Babak says:

    Graeme, check your email – I’ve sent you the file in CSV format.

  4. Pingback: Putting The Volatility (VIX) Put Call Ratio To Rest | tradersnarrative

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