Question
:
How can you offset the risk of falling volatility when buying protective puts with the VIX above 30?
Answer
:
VX Futures
On March 14, options on Bear Stearns (BSC)
were buzzing with activity. The stock was trading near $30 and traders watched in bewilderment as puts with strikes of $10, $7.50, and even $5 saw a sharp increase in buying interest. According to the street, the firm was seeing a mass exodus from its prime brokerage business amid a loss in counterparty confidence. The liquidity squeeze was unsustainable and, heading into the weekend, there were serious concerns about solvency.
Many investors turned to S&P 500 options for defense. On the Chicago Board Options Exchange, 606,755 S&P puts traded, more than double the number of calls. Meanwhile, the CBOE Volatility Index (VIX), the market’s fear gauge, rallied from 27.29 on March 13 to 31.16 late Friday. Increasing SPX put volume along with a rising VIX are reliable indications that investors are seeking protection.
The worries that infected the market on March 14 proved well-founded, as, over the weekend, JP Morgan Chase secured a deal to acquire BSC for $2 per share, a 93% discount to Friday’s closing price. BSC shares plunged on the news and the equity market faced another round of selling pressure Monday morning. The S&P 500 Index fell 12 points and VIX closed above 32. While stocks did fall again on Monday, buying S&P 500 Index puts on March 14 proved to be a losing strategy. On March 18, Federal Reserve officials announced an interest rate cut and, by late Tuesday, the S&P 500 had rebounded above its March 14 close.
VIX collapsed (see “Look out below”). On March 18, VIX lost 6.45 points to 25.79, about 20%. Since the VIX reflects the expected volatility priced into S&P 500 options, when it falls precipitously, it indicates that option premiums are getting cheaper. Traders call this a “volatility crush.”
Let’s quantify it. On March 14, when VIX was moving above 30, the S&P 500 was trading near 1,290 and the April 1300 put was offered at $53. By late Tuesday, the same contract was bid for $25, or $28 and 52.8% lower. Now, some of that loss is due to the bid/ask spread ($2) and some due to time decay ($1). Roughly three-quarters ($21) of that loss was due to the rebound in the S&P 500. However, falling levels of expected volatility also played a role. Roughly $4, or 7.5%, of the loss in premium is due to the volatility crush.