U.S. News

Options Report: Playing and Dealing With Volatility

Jim Kingsland

Volatility is the life blood of the options markets, and investors have been getting plenty of it amid the implosion of the housing market and worries about tightening credit.

Bill Luby, the author of the VIX and More blog, a site that specializes in coverage of the Volatility Index, says we've come a long way from January when "it was widely accepted that volatility had died, crushed by the weight of an ocean of global liquidity."

The Volatility Index (VIX) is a measure of investor sentiment based on fluctuations in trading activity in options linked to S&P 500 stocks. A higher figures indicates investor pessimism about the index, while a low number suggests optimism.

With the VIX now in the 20's -- meaning the index has roughly doubled this year -- traders see plenty of opportuities to play volatility.

Says Randy Frederick, director of derivatives at Charles Schawb, "If you're an active options trader, right now there are opportunities to trade on volatility." 

Frederick favors strategies that have more short options than long options. "That could be selling uncovered options, although that's a little risky -- any kind of strategy spreads that have more short options are going to benefit from higher volatility. Then as volatility settles down a little bit, those options will lose value, which is really what you want, because you want your short options to lose a little bit of value."

By "settling down," Frederick expects that the "15 to 16 percent range (in the VIX) is reasonable for the next 30 days, at least."

Credit market concerns that have dogged investors have also been showing up in the pricing of finance-related options and in companies highly dependent on the credit markets.

"Market volatility is mainly affecting selected areas like the financials," according to Paul Foster, options strategist at theflyonthewall.com. "The real issue is whether high volatilities will spill over to other issues away from financial stocks.  When you look at volatilities associated with the semiconductors and the Russell 2000, they are fairly flat."

Foster suggests looking no further than General Motors to confirm fear surrounding issues either directly tied to credit markets or highly dependent on them.  "GM reports earnings on Monday, and along with concerns about tighter credit, its implied volatility is elevated at 53 percent, well above its 26-week average volatility of 37 percent.

Foster says a variety of stocks other than GM have seen spikes in volatility over the past two sessions.

Countrywide Financial , the largest U.S. home mortgage lender, has seen its August option implied volatility climb to almost 50 percent, up from an average of 35.

As shares of Blackstone slide, implied volatility in its options has surged to 65 percent, well above its 3-week average of 42.

Other surging implied volatility names include American Home Mortgage, CIT Group, Bear Stearns, Wells Fargo, Fortress Investment and Sun Trust Banks.

Stocks Linked to High-Volatility Options

Foster also says rising volatilities in some of the financial names are not merely reflecting perceived risks from tightening credit markets, but a desire on the part of market makers -- the firms which make markets in options -- to discourage options speculation in the names by making options more expensive and less liquid by widening the spread between the bid price and the offer price.

Some of the market makers have been shell shocked by the sudden large moves in financial stocks in recent days, Foster says. "I suppose the ones that made money will continue to aggressively make markets, and the ones who have lost money will reduce liquidity and volatility will stay high."