Where's The Volatility?

At the close of business on July 2 we noticed that implied volatility levels had finally dropped to levels indicating that investor and trader sentiment was too optimistic. With little fear evident in the option premiums, combined with low put/call ratios for the major option indices, it was evident that the market was ready for a correction. In fact, we commented that there was "an increased probability of a 5% correction for the major indices" to Kopin Tan of Dow Jones Newswires.

During the next several sessions, the Dow Jones Industrial Average (DJIA) declined 4.5%, the S&P 100 Index (OEX) dropped 6.1%, the S&P 500 Index (SPX) fell 5.5%, the NASDAQ Composite Index (COMPQ) lost 10.0%, and the NASDAQ 100 Index (NDX) slid 12.4%. In other words, the readings of implied volatility were fairly accurate in predicting a notable adjustment to stock prices.

The quick downturn in prices created a buying opportunity for investors as companies geared up for their reporting of second quarter results. Volatility levels rose from their lows, but never reached levels that would have produced short-term "buy" signals. In fact, they failed to reach readings that many would have called "oversold." This is evident on the S&P 100 Implied Volatility Chart, shown below. Note the interpreted signal at Point-A. Also note that the implied volatility chart never reached excessive levels to produce a "Buy" signal.

So the question now facing options traders is "Where's the volatility?" Has volatility abandoned us, or has it taken a summer-time vacation? Is the loyalty to volatility confused, or has it left us for another market? Have we been jilted or is there more downside to come? And when will we know the answers to these questions?

Since May, trading activity has been rather anemic for U.S. stocks. Confusion over the direction of the economy, an increase in layoffs by corporations, verbal warnings that quarterly profits would not meet their anticipated marks, and indecision by investors have all contributed to lower option premiums. Activity on the options exchanges has dropped and floor traders appear to be taking a vacation this year. Market-makers are having an increasingly difficult time making money, as spreads narrow and costs increase.

INTEREST RATES HAVE AFFECTED PREMIUMS
One of the negative impacts of declining interest rates is their impact on option premiums. The cost-of-carry factor in option models shows that option premiums for puts and calls drop when interest rates drop. This is due to the economic cost of engaging a strategy. For example, if we were to borrow the capital for purchasing 100 shares of a stock priced at $80, for a period of 45 days at an annual interest rate of 8%, our interest cost for that period would be $80.00. Conversely, if the annual interest rate were to drop to 5%, the cost for that same period would be reduced to $50.00. This basically mimics the effect on option premiums caused by the easing of the Federal Reserve since January 3. Since the cost of holding the shares has dropped, the premiums required to compensate for the cost-of-carry have also dropped.

Falling option premiums cause implied volatility levels to also fall. This is due to two factors. First, lower interest rates also imply a lower level of risk for would-be stock buyers, therefore lowering the risk premiums associated with options contracts. Second, when option premiums decline, so does interest in purchasing or selling quality option contracts. We define quality option contracts as in-the-money or at-the-money contracts with more than 30 days till expiration. Our definition removes the highly speculative "cheap" contracts that are purchased by people attempting to make a quick grand profit with little investment.

AN ADJUSTMENT MIGHT BE NEEDED
Changing times call for changing attitudes. The prospect that volatility levels may remain toward the low end of the range has caused us to re-evaluate our assessment of implied volatility levels. Thus, an adjustment downward of 2% for oversold implied volatility readings may be warranted. This would help to compensate for the lower implied risks of lower interest rates. And while this adjustment would probably not have produced a "buy" signal during the recent downward movement, it would have provided a cautionary flag that the decline was nearly over or that a short-term oversold bounce might be due.

During periods of adjustments and uncertainty it is important to keep the primary objective in focus…CAPITAL PRESERVATION. The fact that implied volatility levels have declined does not necessarily indicate a lower level of risk. It indicates a lower level of perceived risk, which has been a contrary indicator.

STRATEGY FOCUS
When premiums shrink there is a change in strategy utilization. Remember that it is better to purchase intrinsic or economic value and to write premiums. Additionally, low premium/volatility levels have been coincident with market or stock tops. This is usually a good opportunity to hedge long stock positions with protective puts, or an attractive opportunity to purchase long-term calls (LEAPS) on stocks that are considered as positive opportunities on a long-term basis.

The Ivolatility website provides attractive tools and data to aid in analyzing sentiment based on risk premiums, and to evaluate certain strategies. We continue to suggest the use of the conservative covered call writing strategies for stocks that you believe are positive, and have higher-than-average implied volatility levels. The covered call writing scanner, available on the website, can help find options with high premiums.