Scaring Down Some Volatility

This is from the Daily Options Report by Adam Warner who writes about a feedback loop where lower volatility induces options sellers to sell more options and further reduce implied volatility.

So what doesn’t move volatility? An low delta OTM call spread in a VIX product to name one thing.

What actually does? Well, stuff like this, from OptionsMonster last Friday (free sub. required).

If you’ve ever wondered where volatility goes to die, read on.

Two recent trades made bear important lessons on why the VIX is near its lowest levels in nine months.

In the largest of these transactions, 200,000 calls and puts on the iShares Silver ETF were sold, and only 75,000 calls were bought. It followed a similar trade on the SPDR Gold Shares exchange traded fund, where 33,000 options were dumped on the market while only 16,500 were taken back out in the form of purchases.

These kinds of trades set off a chain reaction that helps explain why the VIX has plunged in recent weeks. The volatility index is at its lowest levels since September.

As trades like this become more common, they are bringing volatility down. And as volatility subsides, traders bring in less premium selling out-of-the money options. They respond by selling even more options, which then depresses volatility everywhere. We noticed traders using this tactic with Gap options as well, selling twice as many GPS contracts as they bought. Since then the strategy has also been used on McKesson and Baxter International contracts as well.

I’d replace “strategy” with “order flow” above, as it’s not necessarily the same players buying and selling. But the point is spot on. As more call sellers come in, it sets off a daisy chain of bad news for volatility.

Market makers buy all the calls for sale and now find themselves long gamma. They react by lowering options bids across the boards, and attempting to make back some options decay in the stock via shorting into strength and buying into weakness. On the margins both the lower options volatility and increased liquidity in the stock serve to pressure realized volatility down. Which in turn may translate into even more interest in shorting options ever cheaper.

Rinse and repeat.

Index volatility depends partly on the volatility of the component stocks themselves. So as that decreases, it necessarily decreases index volatility.

And this is indeed much of what we’ve seen. At least until Monday as the VIX has turned up a bit.