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Is the Volatility Market Too Complacent?

Equity markets have seen the steepest correction since this past summer.

But the volatility market seems “flat” — does this mean we have lower to go?

Here is a daily chart of the VIX:

While equities have cascaded lower, there has not been a higher high registered in the VIX. Is the fear index broken?

Probably not.

The first thing to consider is that you can’t view the VIX in a vacuum– you have to consider other assets and other timeframes.

The VIX is a 30-day reading, which means it shows what the market expects in 30 days.

What’s in 30 days? The winter holidays– this time normally marks low realized volatility as trade facilitation is lower as institutions wrap up their books for the end of year.

Can we look at a longer term volatility reading? Yes– the VXV is a 90-day volatility measurement:

So longer term volatility has been making higher highs with the equity downdraft– this shows us that there is a “normal” reaction in the volatility markets, just further out in time.

There is also one other cause to the supply in the options market– investors are using covered calls to take advantage of special dividends and to hedge against tax-based risk in 2013.

Here’s a detailed explanation by geckler from twitter:

The volatility skew has thrown a few less talented traders for a loop as the VIX has broken correlation with other risk indicators. The reason for this the one reliable trade still out there: the covered call write on high dividend names in order to capture special dividends companies are issuing ever since WYNN got the show started last month. The offer of at-the-money and slightly out-of-the-money options has had a drag-on negative effect on the VIX where traders would otherwise expect an aggressive volatility bid.

Overall my trade thesis remains the same– if you’re going to sell options, go further out in time to reduce initial risk and have a better expectancy over time.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/