The Stock Sleuth

Detecting deep values in turbulent markets

Lowest Volatility in the Monthly Options Cycle Could Be Next Week

On average, the last days of the monthly cycle (the two days before expiration, i.e. Apr. 18,19 this month) and the first five days of the new cycle have historical significance when it comes to the VIX. What is comical about the financial punditry is that when volatility spikes, like it did over the last 10 days, or last fall during the budget/Eurozone mess, you have talking heads inevitably come out of their holes to proselytize that “volatility is here to stay”. It never has, and never will. It simply just can’t be that way by its very nature.

The VIX is essentially based on the skew (difference) between equivalent put and call prices.¬† There is more to the formula, but let’s leave it at that for simplicity as this is the real key. When investors are afraid, put demand rises, the skew rises, and the VIX elevates. It costs money to protect positions or speculate on sell-offs. The easiest way to think about this might be the Credit Suisse fear barometer. If you can sell a call on a stock at $1 above the strike price, and only get an equivalent amount of put protection for that dollar at $2 below the strike price, then clearly puts are expensive. So, every single month people aren’t going to buy options at high prices to protect their portfolio when it will just eat the principal away.

There is a monthly settlement and roll-out of derivative positions that occurs the third week of every month. That is what happened this week. At the end of options expiration week (opex), volatility cools off generally, provided there’s no major macro shock. The following week is generally a low volatility week; on average the lowest volatility occurs over the next several days.

So, VXX fans (the VIX short-term futures ETN) that don’t read the prospectus are amazed when the S&P falls and the VIX and VXX go down. This should not come as a surprise. The futures generally fall as time premium passes away and the ETN has to roll into¬† more expensive prices into the next month every day. This is a massive headwind when the VIX futures are in contango. (the front month is less expensive than the following month, the reverse is backwardation)

For much more on this fabulous topic, see Adam Warner’s “Options Volatility Trading”, a terrific book on understanding the VIX, volatility, and volatility ETFs/ETN’s.

 

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  1. [...] Lowest Volatility in the Monthly Options Cycle Could Be Next Week-April 20th [...]

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