April Option Advisor: The Story Behind the Falling VIX

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The steady decline in the CBOE Volatility Index (VIX) over the course of the market's rally from the March 2009 bottom has been noted time and again in the financial media, and, indeed, over the past 12 months the VIX has declined by an eye-opening 58%. But this pales in comparison to the decline in the implied volatility (IV) of many options on industry-specific exchange-traded funds (ETFs) and individual equities. The table below shows some examples of IV declines from the March 2009 peaks and is based on the Schaeffer's Volatility Index, our exclusive measure of equity option pricing.



Why has the pricing of equity options taken a bigger hit over this period than that for index options as represented by the VIX? In my opinion, it is "the fear factor" that continues to dominate the pricing of index options - the concern about a sudden market crash. Since index options in general, and S&P 500 Index (SPX) options in particular, are predominant among those used to hedge portfolios against such dire eventualities, these options (and hence the VIX, which is a measure of their volatility) are always "juiced" due to excess demand for crash protection. An indication of the degree of "juice" in an options class is how implied volatility for the options in that class compares to recent historical volatility, and in this regard I'd note that while the VIX is in the 18 area, recent historical volatility of the S&P is well below 10%.



In fact, index options have been expensive on this basis for many years, which is supported by the success over the years of a number of real-world index premium-selling strategies. According to the Chicago Board Options Exchange (CBOE) Web site, in 2006 Callan Associates published a study on the CBOE S&P 500 BuyWrite Index (BXM) that concluded that BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk. And our Wealthbuilder Series, which recommends trades utilizing index credit spreads and iron condors, has profited on 79% of its recommendations since 1993.

But on the flip side, equity options are quite cheap - relative to index options and relative to their levels of just one year ago. And this presents an excellent opportunity for option premium buyers. The traditional "strategy spectrum" recommendations under such conditions would be to buy cheap call options as "stock substitutes" and pocket the difference between the capital required to own the shares and that required to buy the calls. Or to buy cheap put options to protect your stock portfolio (with the caveat that you pay up if you use index puts as your vehicle). My suggestion would be to combine the best of both of these worlds by buying call options paired with lower-delta put options on the same stock to benefit from cheap "stock substitution" and the cheapest put protection.

Bencat

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