Friday's 13.8% VIX Slammer!

I’ve noticed a prevalence of commentary over the weekend by pundits, bloggers, tweeters and the like talking about how Friday’s near 14% drop in the VIX was a strong indicator that S&P 500 Index is positioned for a magnificent Santa Claus rally into the holidays.  While it’s certainly true that Friday's VIX drop was enormous compared to the 1.7% rise in SPX, there are two points that can’t be ignored:

The normal post-event volatility collapse

Just like an earnings event, the lead up into the European Summit included a rise in volatility.  I apologize if I’m pointing out the obvious, but note that both the VIX and the SPX were up on Monday, Tuesday and Wednesday.  This unusual occurrence is not unusual at all leading into an event such as earnings, as traders buy protection against a violent price move.

I’ve noticed a prevalence of commentary over the weekend by pundits, bloggers, tweeters and the like talking about how Friday’s near 14% drop in the VIX was a strong indicator that S&P 500 Index is positioned for a magnificent Santa Claus rally into the holidays.  While it’s certainly true that Friday's VIX drop was enormous compared to the 1.7% rise in SPX, there are two points that can’t be ignored:

The normal post-event volatility collapse

Just like an earnings event, the lead up into the European Summit included a rise in volatility.  I apologize if I’m pointing out the obvious, but note that both the VIX and the SPX were up on Monday, Tuesday and Wednesday.  This unusual occurrence is not unusual at all leading into an event such as earnings, as traders buy protection against a violent price move.

And just like the typical earnings announcement, when the event is over and the risk of a large price move is gone, the demand for protection disappears and the volatility of the options collapses.  This type of collapse can most certainly be seen in Friday’s VIX drop upon the release of the Euro Summit news.

Weekend Decay

Every Friday, the VIX sees some loss in value as the options market removes the weekend premium from SPX options.  Since the markets are closed from Friday at 4pm until Monday at 9:30am EST, there are 65.5 hours of time where options will see no intrinsic shift in value.  Premium sellers could theoretically profit by selling options at the close on Friday and purchasing them back Monday morning, with the weekend’s time premium discounted out.  To protect against this, market makers will simply remove the weekend’s time premium from the options ahead of time.  This can be seen in a slight decline in implied volatility.

While these two points don’t explain the enormous drop in the VIX, they should not be ignored as if they didn’t exist.  That being said, I do think Friday’s volatility drop does point towards some market stability going forward.  The volatility of the Dow (VXD), the Nadsaq (VXN), and the Russell (RVX) as well as just about every major name is at the low or breaking below the lowest end of their recent ranges.

SPX IV30 from Livevol Pro. While IV is at the bottom of its recent range, it is at the higher end of the longer term range

 

This is making trading decisions a little tricky in that these types of lows normally beg the option trader to buy premium.  For the trader without a directional bias, this would normally mean it is high time to purchase a straddle.  However, while many names are at the lower ends of their recent ranges, they are at the high end of their longer term range.  In the case of the SPX (pictured below), I suspect that a price break above 1260 (where the 200 SMA and the 61.8% fib line sit) with follow thru will signify a new lower range of implied volatility.  On the flip side, a significant breakdown below the 1225 area (where the 20 SMA sits as well as the 50% fib line and previous support/ resistance) will give us a nice volatility pop.

SPX Price Chart

 

Given the seasonal declines in volatility and a European hangover, I’m inclined to lean towards volatility declining slowly into the holidays with the occasional pop here and there and will be watching for price confirmation at the 1260 and 1225 levels.

 



Comments

Jason Alexander's picture
12th of December 2011 - 11:16am
Jasonalexander

As an interesting post-script to yesterday's post, today we saw the SPX down 1.5% with the VIX down 2.7% This is especially strange in that today is a Monday and the VIX generally sees some strength as premium is added back into SPX options in retaliation for too much being taken out Friday. At the same time, today the VIX futures are up across the board, with Dec up 1.29% and Jan up 1.86%. Something very funky is going on and I wish I knew how to explain it. I suspect that we are seeing some kind of confluence of the post-event volatility collapse that I mention above with the seasonal decline in volatility as the holidays approach. But I am conjecturing here as I am honestly confused by today's movement in volatility. One thing is for sure: the options market is not buying today's pull back in price. If I can risk another conjecture, I'd say everyone is either already hedged or is using today's pull back as an opportunity to sell premium. Indeed the Nasdaq (NDX) is presenting an interesting opportunity with price sitting on a consolidation of the 20, 50 and 200 SMA's. This presents a relatively low risk long opportunity as a drop below the moving averages would be the stop loss.

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