Monday morning, the CBOE Volatility Index ($VIX) rose above 20.00 for the first time since June 2006. At that level, the market's so-called "fear gauge" is almost two times higher than it was just one week ago. Since VIX measures the expected volatility priced into S&P 500 Index ($SPX) options, the rise in the volatility index is a sign that expectations about future market volatility are on the rise. It is a trend seen throughout the US options market and has been especially noticeable within the financials.
Expected or implied volatility [IV] is a measure of an asset's volatility based on the prices of that asset's option premiums. For example, VIX is computed using a model and S&P 500 Index options. When it rises, it indicates that SPX option premiums are becoming more expensive, which often occurs when the market begins to experience big swings from one day to the next. Similarly, each stock option contract has a unique level of implied volatility, which tends to rise when investors believe that stock will exhibit increasing volatility going forward. For example, implied volatility often rises ahead of an earnings report. The increase in option premiums due to a sudden increase in IV is known as a volatility rush. On the other hand, IV will fall after the stock reacts to earnings reports, which is known as a volatility crush.
When an option sees a volatility rush, it's premium will rise. The increase in the premium is due to the increase in implied volatility. So, when IV is high, options are said to be "expensive." However, when implied volatility falls, the contract is getting cheaper. Low implied volatility equals "cheap" options and high implied volatility equals "expensive" premiums.
How does one know if options are cheap or expensive? One way to search for cheap and expensive options is with the free ranker available on the home page optionetics.com. I used the "expensive" screen Monday morning and the top 10 stocks from that search are listed in Table 1. Seven of those ten stocks are financials. For example, over the past twelve months, Citigroup (C) has a high implied volatility of 24.78% and a low of 13.39%. Recently, it was at 22.78% and closer to the upper end of its range. These options are expensive relative to the trend over the past twelve months.
Bank of America
Bank of New York
Table 1: Top Ten "Expensive" Options (March 5, 2007)
Another way to see whether implied volatility is high or low is with a chart. Several options analysis software programs can create IV charts. Figure 1 shows a two-year chart created with Optionetics Platinum for Merrill Lynch (MER). As we can see, the implied volatility (of options expiring between 30 and 60 days) is 33%, which is the highest since June 2006 and at the upper end of the range. The chart confirms the information from Table 1. Merrill Lynch options are expensive.
Figure 1: MER Implied Volatility [IV]
Knowing whether IV is high or low can help options strategists determine whether options are cheap or expensive, but also help make sense of the action in the stock market. Obviously, VIX is high because the recent stock market slide has pushed up volatility perceptions throughout the stock market. At the same time, the financials are seeing a big increase in implied volatility amid concerns about the recent stock market slide as well as the problems in the subprime mortgage market. Indeed, the financials have been leading the stock market lower as fears of a credit crunch have derailed shares of many mortgage companies, banks, and brokers.
Now, the option premiums are pumped up throughout the financial sector because investors are worried and are anticipating additional volatility in the sector going forward. These worries are also weighing heavily on the entire stock market. Until that fear begins to subside, which will be evident when IV in the financial sector begins to fall, those concerns are likely to continue weighing on the stock market. In other words, watching the implied volatility of C, MER, and the other financials in Table 1 might be a leading indicator that sentiment is improving and the stock market is set to recover.
Senior Writer & Index Strategist
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