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Shah Gilani

In the early 80s, when I was running a hedge fund from the floor of the Chicago Board of Options Exchange (CBOE), I was a market maker in OEX options. The OEX is the Standard & Poor’s 100 Index. The CBOE Market Volatility Index (VIX ) was born from trading options on the OEX and from our desire to more accurately price risk.

The stock market volatility index (VIX) or fear gauge, as it’s often called has been giving off unexpectedly low readings in 2011.

But don’t be fooled. Things aren’t what they seem.

Structural dynamics are currently suppressing the VIX, and are diminishing its predictive power.

If you want to trade this as a speculative investment or even if you just want to use the VIX to better hedge your portfolio holdings you need to understand the forces that are working on this stock market volatility index.

Let me explain

I Was There for the Birth of the VIX

Back during my hedge-fund days, we used Monchik-Weber machines with their built-in Black-Scholes options pricing formula to help us mathematically measure put and call-option values. The computers would provide us with the theoretical value of the options we were trading.

But it wasn’t long before a gap between those theoretical values and the actual market prices drove us to find a different way to measure volatility. To calculate implied volatility the estimated volatility extracted directly from bids, offers and actual prices we looked at real-time prices as opposed to theory.

Simply put, based on actual prices for calls and puts on the OEX, we separated out implied volatility and used it as a measure of what traders were expecting to happen.

This volatility measure is the expectation of price movement over the next 30 days. The higher the reading, the more likely stocks are to move in one direction or another.

Over time, our volatility index became known as the VIX. And eventually, the VIX not the OEX became a measure of options-pricing volatility based on the Standard & Poor’s 500 Index .

The VIX is called the fear gauge for a good reason: As that index rises, it’s basically telling us that traders and investors are paying a greater premium to buy options, mostly because they are paying up to buy puts.

The Stock Market Volatility Index: What’s at Work?

I’m often asked this question: If there’s fear in the marketplace and traders are buying puts and their prices are increasing, and they are selling calls and their prices are decreasing why don’t the two cancel each other out and the VIX react less dramatically?

That’s a great question.

And the answer comes in two parts.

First, selling calls is a hedge against falling stock prices. But when you sell calls against a position you hold, you only collect the premium or payment that you sold the calls for. No matter how far the stock falls, your downside protection is limited to the money that you collected for selling the calls, meaning this hedge has limited value.

On the other hand, by buying puts, you can hedge or profit from a steep-and-lengthy drop in the price of the underlying stock. Even more important, in a sell-off or outright panic, investors and traders are more inclined to buy puts as protection or as a speculative position without too much concern for the prices they have to pay. That’s why volatility spikes in fearful markets.

That brings us to the current situation. I think we’d all agree that there’s been an awful lot of fear in the markets of late. And yet the stock market volatility index the VIX has remained stubbornly below (often well below) its historical norm of about 21.

So just what’s going on here?

Going by these low VIX readings, investors and traders have been shrugging off a whole host of negatives that are hanging over the stock market. Bullish investors would have us believe that stock prices are very effectively climbing the proverbial wall of worry , meaning the market sees good times ahead for stocks.

That may be true. But there’s also more to the story.

The Rest of the Story

Before the markets reached recent highs this past spring, investors and traders began protecting accumulated profits by selling calls against their holdings. I’m not just talking about individual investors; I’m talking about institutional players, too.

At the time, all sorts of potential market headwinds were grabbing headlines everything from the twin tragedies (earthquake/tsunami and nuclear disaster) in Japan, inflationary fears and the approaching end to QE2 here in the United States, soaring oil and commodity prices, and the convulsions in the Middle East, to name just a few.

What we saw was that put buying was met head-on by even-more-robust call selling. So while the buying of protective puts should have lifted the VIX, a steady stream of call selling was offsetting what would otherwise have been generally widening premiums.

The more the markets digested the bad-news headwinds and the higher stocks edged, the less put-option prices were being bid up. What’s more, as things have quickly settled, call sellers have added to the downward direction of the stock market volatility index.

But there are larger, more-important structural dynamics working to keep the VIX low.

For one thing, the so-called reach for yield in a very-low-interest-rate environment is causing investors and especially institutions to sell calls against stock holdings in order to generate income.

Demographics are playing a role, too. Baby boomers have started to retire. As boomers age, they are switching from stocks to fixed-income investments, which reduces the demand for put protection as they unwind their equity holdings.

Hedging and Speculation Strategies

The real question to ask is: So where do we go from here?

It remains to be seen whether the selling of calls for income is a statement that investors believe the market has limited upside. If so, that would mean that they’re willing to trade away the small chance that there will be a substantial increase in stock prices in return for a boost in their income.

It also remains to be seen whether a low VIX means that the premium options sell for is lower, making it necessary to sell more options to garner additional income. If that’s the case, the lower level of this stock market volatility index would be structural, and thus self-sustaining.

But it’s also possible that a terrible danger is lurking behind these low VIX readings. And that’s something you need to beware of: Just because it appears as if the markets have adjusted to all these headwinds and haven’t corrected meaningfully doesn’t mean that they won’t.

That brings us to hedging and speculation strategies.

In terms of hedging, what I can tell you is this: The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices. In the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection just in case.

For traders of the VIX, holding positions for big moves is out of fashion and foolish. Until the VIX stops trading in narrow bands, traders should take smaller profits and be quicker on the trigger when their trades are in the black. They can always keep a deep out-of-the-money position in calls if they want a longer-term, investment-type play.

Although the VIX is a stock market volatility index, traders and investors need to understand that it’s really no different than any other investment instrument meaning that it, too, is vulnerable to structural changes and the dynamics of constantly moving market expectations. You should always understand what’s going on with the instruments you invest in and trade and avoid at all costs getting blindsided by moves that you could have anticipated.

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Articles by Shah Gilani .