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June 22, 2007

Dear Fellow Options Trader,

I've said it repeatedly, on the radio, on CNBC and to you, our beloved subscribers, that volatility has moved into a new, significantly higher range. But before I get into the deep water, bear with me while I briefly explain volatility.

Volatility is a measure of risk. The higher the volatility, the larger the price fluctuations we expect. Conversely, the lower the volatility, the tighter the range of price fluctuations.

There are two types of volatility that I track and care about. They are historical volatility and implied volatility. Historical volatility shows what the actual movements of the asset were during a period of time. Implied volatility is the measurement or level we examine to justify the option's current market price.

Now as the first graph I've included shows, volatility of the S&P 500, as measured by the Chicago Board Options Exchange's Volatility Index (VIX), was bumping along in the 10 to 12 range for months. The catalyst that bumped it up in late March was the one-two punch of the Chinese market meltdown and our own American subprime-mortgage slime.



There was also a nasty little disconnect with the NYSE, in which it couldn't keep up with the massive trading volumes on Feb. 27 and had to shut down/restart its servers. Those watching the markets saw the Dow fall from being down 350 points to down 530 (and back up again in fewer than 10 minutes).

But really, the NYSE had to add more servers -- that is, the markets weren't down as far as they actually appeared. Meanwhile, the market-makers saw this and had an unfair advantage, as they were buying calls while others were buying puts.

When all of that was going on, though, risk managers forced those traders who were short volatility to cover as their losses mounted. This is something I have repeatedly seen during my 26-year trading career -- and it is the stock-market equivalent of throwing gasoline on a fire, as the panic-buying of put options accelerates the fall.

Since late February, we've not seen the VIX trade below 12 for more than just a few minutes in time. I've heard of several large hedge funds, such as D.E. Shaw, buying straddles out in 2008 and 2009. (A straddle is a strategy in which you have both a call and a put with the same strike price and expiration month.)

Apparently Mr. Shaw's systems determined that volatility would remain higher, and his firm's purchase of a long call and long put in individual equities as well as several indices demonstrates that he's put his money where his mouth is. The straddle is a risky strategy, and it depends greatly on the stock making a big movement either to the upside or the downside (as you're protected in both directions), while a small move in the stock generally means the trader would incur a loss.

I see several reasons why I'm in good company calling for the higher range of volatility, and here are my top three:

Interest Rates -- The 0.625% move in interest rates during the past month is more than just a wake-up call. While I don't think we'll push higher than 5.4% for the 30-year bond yield, I do think that the capital commitment to stocks has significant competition from fixed income with the S&P 500 and Dow Industrials near record levels.



Tax Changes -- The Blackstone Group's initial public offering put the focus on how much money is made, and how little is paid by partnerships like this private-equity giant. While Congress failed to stop the IPO, the jawboning about increasing taxes on the sector and/or elsewhere will promote uncertainty. And that, friends, means higher volatility.

Markets at Highs -- The run has been so strong for so many months that those with gains who want to stay invested will be buyers of protection, and this will contribute to higher VIX measures as well.

As options traders, we benefit greatly not only from added volume, but also higher volatility. Small moves don't necessarily interest us, because although we'll take a profit wherever we can get it, the big moves that take place when other investors are fearful are what can bring the most-significant gains to our portfolios.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader