A Review of Recent Volatility
By Michael Williams of NCompass*
Posted: Sep 29, 2006

General option premiums have come in quite a bit over the last expiration cycle, but we have still been seeing large skews between the out-of-the-money (OTM) calls versus puts. I think these remain because of the overly cautious hedging going on. While August expiration had low volume and declining volatility, we did see continuing hedging into the early September period.

This skew in the OTM puts will remain high until we see some confidence build back into the market. With the continuing geo-political and economical issues remaining questionable, we will see the continuation of hedging, thus the continuation of the increase in put premiums.

It is important to note that the VIX and VXN do not measure skew and only take a weighting average of the at-the-money (ATM) calls and puts. While this may reflect a general, lower implied volatility, it fails to give a clear picture that the still-heavy put buying and call selling are creating a skew. It is important to keep track of the skew because it helps establish a better resolution of market confidence.

We also saw a brief pop in both the VIX and VXN with the pull-back -- as if the buyers of this market stepped off the gas for a bit. The rally was strong and on light volume.

It almost seems that large investors are betting on an upward market but not without insurance for their portfolios. This trend is nothing new. Yet, we are seeing a larger increase in option-to-stock volume.

Short and hard rallies in the market drive premiums down, create large skews and increase the short interest in the underlying, all of which set up sharp pull-backs and premium explosions.

VIX is traditionally a contra-indicator. When it moves in a slowing pace to very low levels, it usually coincides with a topping market. When it reaches very high levels in short bursts, it usually indicates an over-reaction and a bottom in the market.

The recent low level in the VIX was 10. If it trends lower and drops below 10, it will probably coincide with a coming correction in the market.
 
See the overlay shown subsequently:

A Major Index Review

INDU -- The Dow has really done well since its pull-back in May to 10800. It has recovered 5 percent in two months. The rally was more of a quick rebound than a rally, and the volume has been on the light side. It would have been better to see a slower rally with heavy volume. This points to the volatile times we are in.

If you had participated in this rally, I would have taken some off the table in anticipation of a pull-back to test 11200, which would be a support area. However, it is very important to remember that this is only 30 stocks and not really a good representative of the market. It is more of a psychological index than anything else.

COMP -- The NASDAQ Composite, also widely watched, didn’t get back to the previous highs that it had in May. It has already been facing some resistance at 2200 and has pulled back. This is a more accurate reflection of the marketplace.

The SPX and OEX -- These two indices ripped right back to their previous spots before the May sell-off but, then, were facing their previous resistant points (1300 and 600, respectively).

The broad-based RUT (Russell) never got back up to 780. It too lost momentum.

From the “1,000-foot view”, it seems that the market sold off as a reaction to the higher oil prices, Middle East conflict, North Korea, interest rate hikes, and so forth. Then, when nothing really happened -- other than gas prices going up -- well, the market got back on the bandwagon and started rebounding by leaps and bounds. As if everyone forgot why the market sold off in May!

While it’s true we may have missed a bullet, I think it is still prudent to remain cautious when taking long positions. It is already obvious recently that the institutional buyers of puts are taking the downside risk seriously. If they are hedging their bets, why aren’t you?

There is nothing wrong with putting some extra puts in your pocket -- when and if something does happen.

*Reprinted (and modified) with permission from Michael Williams (www.marketcompass.com and www.ncompass.us.com)