There are rules of thumb in every field of interest. I am referring to certain generalizations and assumptions that people make and observe. In the markets there are many but one that catches my attention lately is the correlation between the directional movement of the market and the volatility that is expressed in option pricing. The rule of thumb is; when markets go up the volatility goes down. Recently there is a glaring inconstancy to this assumption and it needs to be noted.



This is a reasonable correlation because of the strong influence of human nature in market psychology. Human nature is reflected in market price action because of the general attitude that Up is good and Down is bad. Since most market participants are Long (or own) equities, the only way to make money is if they go up in value. If the market is moving up there is tendency to relax and feel good. The option world is primarily a hedging environment so risk management is the primary objective. Options were created to hedge risk so if the market is headed down the price of the option (to hedge risk) goes up. The time value of the option is what fluctuates with the fear factor, time value is a flexible number and reflects the relative risk of writing options which obligate the writer for months at a time. So the price of risk is reflected in the volatility of the options by the cost of time value.

The human nature part of this basically dictates that when the market goes up we relax and fear abates, risk is perceived as low and the time value goes down. Generally this correlation works and we see volatility go down with rising markets and up with falling markets. The occurrences of discrepancy are often associated with experienced markets sensing a change and hedging the move. In other words the traders and some major players sort of jump the gun and start to adjust prices that will give them an edge if they are right. This is high stakes and can backfire but the adage that insiders and veterans are often right and ahead of the curve comes from some where and must have some truth to it. So the discrepancy of the last two weeks is big enough to note.

Now I have been the champion for the idea that you follow the stock or market movement regardless of the news or indicators and I am not deviating form that position. Nonetheless I do follow key indicators and not ether signals. When the stock or market does move to represent the indicators signal then I move on it. But I note the signal and am thereby ready to move when and if the predicted move comes.

Note that the volatility indicator for the OEX (S&P 100) is called the VIX. Above, the VIX is the purple line and the OEX is the chart. The normal pattern is for the OEX and the VIX to run opposite each other and make significant turns at opposite ends of their respective scales. Also note that when there are discrepancies, VIX is generally predictive of the outcome. In other words, the traders that price the options will sometimes start to price in an action before it actually happens. Again this is risky for them but risk is their game and so if they sense a change coming and they are confident enough in it, they will start changing the price bias ahead of the move.

Note the divergence in March and April. The market rallied up in March and the VIX dropped with it. The market suddenly dropped and the $VIX continued to march on down. If the option traders believed that the drop signaled and reversal of fortune for the market they would have swung the price of risk (volatility) back up to cover the perceived risk. They did not and after a week and a half pullback the market resumed its climb and the VIX continued to drop. The previous few months the VIX and OEX had moved in a nice rhythm of opposing swings.

Now note the last few weeks. The last run up in the market has seen the VIX make rounding bottom and head back up. This is note worthy because the market action has been straight up and bold but the volatility is being added back into the pricing which is clear signal of perceived risk / fear. Now this is not infallible and it is risky to oppose the momentum of the market but there is some BIG money at stake here and bold moves are not made lightly. There is a perception at some rather high levels that it may be time to "store some nuts for the winter" or "stock up on groceries" if you get my drift.

In the NASDAQ which has volatility indicator called the VXN. Here the discrepancy is even more pronounced and as the NASDAQ screams upward on the backs of Biotech and High tech components, the volatility is increasing. This is opposite of normal market action and begs the question? who knows what? Why is fear being priced into a major run up? If it continues there will be a sharp drop in volatility as the market defies gravity and makes believers of the skeptics but what goes up does come down and it appears that a some of the big hedge action is 'Storing Nuts'.

This action is helpful to the owners of calls. The interesting penalty to call buyers is that as the stocks move up the time value is reduced. For put buyers the opposite action helps their position. The imbalance however puts option seller at a disadvantage and this is partly why you see the hedging in price action and the increase in volatility when option writers sense a topping action in the market. They do not want to be selling cheap puts as the market rolls over.

Time will tell and for the moment it is full speed ahead and up we go. But keep in mind that some major money is starting to hedge their bets. The normal option activity for a reversal in the market is to buy puts. The price of those puts is already being inflated in anticipation of a roll over.

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Ryan Litchfield with Better Trades