Options Traders Volatility Bets Suggest Stock Rally Will Resume

I assume readers know that I am a pretty skeptical sort, and don’t expect a lasting stock market recovery until the fat lady sings (as Barry Ritholtz pointed out, in the dot-bomb bear market, the stock market did NOT anticipate economic recovery, but rallied after the economy had started to turn).

But as the Great Depression and the long 1970s bear market show, there can be very large rallies (and of course smaller ones too) before the final bottom is in (and that assumes the US is the model for our current mess, as opposed to, say, the Japanese stock market in the 1990s).

And despite newly bearish sentiment (a lot of blogs and commetators I read have changed their posture in the last week), you can always somewhere, somehow find a factoid that says the stock market will go up. Bloomberg gives us the latest, namely, declining expected volatility in the equity options market.

From Bloomberg:

Options traders are betting stock swings in the Standard & Poor’s 500 Index will decrease at the fastest rate since the aftermath of the market crash in 1987, a sign that equities may keep rallying.

The difference between the benchmark index’s historic volatility and a gauge of so-called implied volatility based on expected swings rose to the highest in 21 years, according to data compiled by Credit Suisse Group AG and Bloomberg. The gap widened as investors paid less to insure against price declines, sending the Chicago Board Options Exchange’s Three-Month Volatility Index lower.

Historical volatility must fall 25 percent to bring the measures into accord. The last time the difference was this wide, stocks climbed for two quarters, according to data compiled by Bloomberg. Declining volatility is usually bullish for equities because it shows growing investor confidence…

Stock swings increased as the collapse of Lehman Brothers Holdings Inc. in September and government actions to bail out banks heightened concern losses would worsen. The S&P 500’s three-month historic volatility has more than quadrupled since June to 62.97. That’s 15.62 points higher than the CBOE’s Three- Month Volatility Index, a measure of expected swings in the S&P 500. They were as much as 29.7 points apart in the past month.

Stocks rallied the last time the difference was this large, just after the S&P 500 plunged 20 percent on Oct. 19, 1987. The index climbed 4.8 percent in the first quarter of 1988 and 12.4 percent that year. The VXO, a predecessor of today’s benchmark volatility index, decreased 31.7 percent in the first quarter and tumbled by 53 percent in 1988, its biggest annual drop.

“The volatility regime is going to shift significantly in the first quarter,” said Stu Rosenthal, who helps oversee $4 billion in volatility strategies at Volaris Volatility Management, a unit of Credit Suisse in New York. “The options market is predicting that the equity market will calm down.”

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  1. Anonymous

    There has to be a big blowup that they already are in discussion with coming soon that needs the money.

    It has to do with something that is expected during earnings season.

    So check your calendars and start making guesses.

    My guess: It is not just C.

    There has to be more.


  2. bg

    1987 was a technical decline near the beginning of the longest bull market in recent history.

    We are in completely different territory.

    ‘ Declining volatility is usually bullish for equities because it shows growing investor confidence…’

    First of all, volatility measures how much (little) liquidity it takes to move price, and may also measure surges in volume. Price measures investor confidence. Volatility does rise with price declines, but with a delay (i.e. rising volatility does not predict declines, it reacts to them.)

    The gap between experienced volatility and implied volatility is like the yield curve. One end of the curve is reporting the recent past, and the other end of the curve is future expectations.

    The gap is (of course) going to go off the map in a crisis, due to expectations of mean regression (which does happen on volatility).

    In bear markets declining implied volatility is a good predictor, and has been an excellent predictor of free falls over the last 18 months.

  3. Anonymous

    Declining volatility is usually bullish for equities because it shows growing investor confidence…

    What a bizarre statement. It could just be more traders writing options because they don’t believe we’ll see another quarter of almost daily 800-pt peak/peak swings.

    Any comparison that uses the word “usually” is meaningless… VXO/VIX has never been this high, we’re in uncharted territory.

  4. Anonymous

    Volatility declines,…

    until it doesn’t.

    The VIX is rising off the 40 level now.

    Please take a look at a chart of the VIX going back 20 years. It has been above 40 only once (September, 1998). Please consider that we have been above 40 for the better part of the last 4 months. Past comparisons are meaningless, as Anon 2:48 says. We are truly in uncharted territory.

  5. Anonymous


    Do you know what you are talking about re 1987? There HAD been a very strong bull market since 1982. Then it went through a rocky period through 1991 (two bear markets) and then had three years of ho-hum gains. The “greatest bull market in history” did not start till 1995. Valuations changed notably starting then.

    Yves was being ironic in featuring this item, in case you didn’t notice.

  6. bg

    anon 3:07am

    I missed the irony.
    She blamed Bush in the prior post for the market going in the wrong direction. Was that irony too?

  7. bg

    anon 3:07am

    I missed the irony.
    She blamed Bush in the prior post for the market going in the wrong direction. Was that irony too?

  8. Charles Frith

    To not rally means they concede the system is broken. They have to rally. It’s all or nothing. Wait and see.

  9. Anonymous

    The irony is pretty clear here. As to the last post, I think it is fair to blame everything on Bush. He didn’t call the plunge protection team out on this one.

    That was a lame joke of my own.

    Her headline on the last one was over the top, but her argument made some sense, or at least highlighted that the official reasons don’t add up, Obama didn’t want a Congressional fight over TARP, it would be bad for the markets. I buy that,

    The timing of pushing it through now is bizarre and does not seem helpful to Obama. I buy that too. How Obama got cornered is beyond me, but that seems to have happened.

    anon 3:07

  10. bg

    anon 307,

    I downloaded sp500 yearly trends starting after the 1987 crash (yearly percentage moves yoy as of nov 1). except the dot-bomb fallout, it looks like a damn spectacular secular bull run. I think 1982 was the low point on P-E. So I think my facts are defensible.

    2008 -39%
    2007 6%
    2006 12%
    2005 6%
    2004 11%
    2003 13%
    2002 -18%
    2001 -13%
    2000 -5%
    1999 19%
    1998 21%
    1997 26%
    1996 25%
    1995 33%
    1994 -2%
    1993 7%
    1992 15%
    1991 16%
    1990 -7%
    1989 26%
    1988 19%

    thanks for working to keep us honest.

  11. Richard Smith


    Anonymous of 3:07 is pointing out that Yves is quoting Bloomberg, not endorsing Bloomberg. That is the irony I think I discern about 3:07’s post, anyway.


    It’s bank earnings season. JPM and BoA will have some idea how their respective horrible acquisitions have been doing. Awareness of nasty results to come would explain why Obama is freeing up some more TARP money. We may find out on the 15th (JPM results).

    Via FT Alphaville: “JPMorgan Chase, the second-largest US bank by assets, on Monday said it will announce Q4 results on Jan 15, six days earlier than planned, reports Reuters.”

    This side of the Bush/Obama handover: must mean *something*

  12. Anonymous


    I looked at a chart from 1970 to present.

    Using Nov 1 is non-standard, and you are pretty much starting from the bottom of the 1987 crash. I’d at least take that out, it was a huge move down and you egg the pudding for at least the first couple of years (there was a mini-crash in 1989, when the UAL deal collapsed, but I think that was in November).

  13. Anonymous

    Maybe JPM has bad earnings, or maybe Bush conned the Obama crowd so they can shovel a bit more cash out as their last act. Only a few days, we’ll see which theory was right.

    Or maybe neither theory is. That would be funny. No disaster, no eleventh hour handouts. Here we all look for conspiracy theories and maybe there are none!

  14. Anonymous

    The irony is not hard to find:

    “you can always somewhere, somehow find a factoid that says the stock market will go up.”

  15. Anonymous

    Since were on the topic of bushie did anyone catch the surreal press conference he just gave and stalked out of the room, Unbelievable head still spinning.


  16. Richard Smith

    Anonymous of 3:54 – too right. An anticlimax would be something to look forward to. Not long to wait, anyway.


  17. Anonymous

    I don’t get the market anymore.

    I own one stock. It’s an Asian stock with no debt. It has $1.50 per share in cash in the bank. I’m not talking about assets and book value, I’m talking about actual cash money sitting in a bank account. It also has products it produces and sells for cash so it has cashflow and business. During the last market drop, it fell down to 60 cents a share. It’s now back over $1 but sheesh! Who can understand this?

  18. Yves Smith

    I was told that the stock market dropped 10% in the last three weeks of the Hoover Administration, before FDR took office. While I think the markets will get a lot cheaper at some point, the change in sentiment seems awfully sudden, and I think this super lame duck phase may be playing into it.

    If C is restructuring, as opposed to being in trouble, that actually ought to be a good thing, as in it is a BIG BIG first step towards cleaning up the banks. But everyone is seeing only the downside in it. Even for a bear like me, I find the C reaction overdone in the absence of more facts. Rubin leaving, for instance, also should have been seen as a plus. The guy was part of the problem. But no, the stock traded down big time on that too.

  19. Richard Smith


    Yes, total mess that allows all sorts of futile speculation. Can’t rely on the stock market being forward looking. If the C moves are a bear raid, they bears are about a year late. But then one suspects that the 100Bn of new capital and 300Bn backstop might not be the last of it either.

    Possibly interesting Q: how does the US banks’ funding gap look now? Have they managed a meaningful amount of deleveraging this year? Some of our UK banks still don’t look at all clever in that respect (notably LoydsTSBHBOS which is a big big bank).

  20. Yves Smith


    I have NO insight here. The banks will pull out all stops to report not awful earnings. Wells played some accounting tricks last year that the market saluted.

    I could be very wrong, but JPM moved up its earning announcement after its stock went down 4% on Monday. Expectations are 5 cents a share. I think it is more likely that JPM will beat or meet expectations than fail them.

    As for the others, NO idea at all. But if even 1/3 do better than expected, and C does not come apart and none is stunningly bad, I think we may see some improvement in sentiment (from panicked to resigned).

    Remember, next week, we have Geithner and the new team talking to the media. Every time Paulson opened his mouth, the market went down. I think Geithner, at least initially, can do better than that.

    That does not make for any long term change, but might alter the trajectory, or lead to a partial retracement of the downdraft under way.

  21. donebenson

    As an old bank analyst, who lived thru the bank bear markets of the early 80’s and early 90’s, I think the big picture here is important.

    Regardless of what near term 4th qtr. earnings they show, the main thing to remember is that the banks still have LOTS of bad debts to write off. And their present equity cannot support immediate write-offs of all that debt.

    Please listen to what Meredith Whitney says. She has been the only bank analyst to get things correct.

    Bottom line: the banks are still in big trouble, and our failure to follow the Swedish example of handling their banks in the early 90’s means the problem won’t go away any time soon.

  22. john bougearel


    And the counterpoint to Bloomberg’s article is to make the observation in passing that amidst declining volatility from an April 1930 high of 297 (a 50% rally off the November 1929 low), the Dow fell 86% to 40 two years later in July 1932.

  23. Bob_in_MA

    What crap. Does anyone really invest based on this kind of nonsense. It’s almost as bad as one of that idiot Mark Hulbert’s columns.

    Hey, the first five letters of my Word Verification were RALLY!

  24. Anonymous

    The markets have been in a false economy since 1988. The Fed decided that any major pull back in the equity markets was bad; using interest rates and the discount window, (remember the bank bail out of the 90’s where the Fed took the cost of funds below the yield on treasuries) the Fed kept the market going up.

    The markets were rigged for success not reality. Talk about uncharted territory, how do you unwind 20 years of a rigged market? Does anyone really expect to see double digit earnings anytime soon? Without the earning what happens to PE ratios? Have the trading models (here we go again) be adjusted to the new earning realities?

    The fact is the traders need volatility to make money, so any story with the word “Bull Market” in it will be pushed out by the trained chimps called market reporters.

  25. Anonymous

    Yves, one of these days I would be curious to read about what it is that leads you to the opinion that the derivatives markets know more about the stock market than the stock market itself. I mean, they may, and I’m open-minded, but I don’t myself see why that would be the case. I am curious what you are seeing there, if you ever feel moved to comment on that. There must be something in the structure of these markets or the instruments they trade that leads you to this view?

  26. john bougearel


    I can’t speak for Yves, but clearly the derivatives market is “home on the range” for the banking industry as a whole. It is where the deer and and the antelope play. Translated, it is where inside information is hedged and traded.

    They are pricing in risks well ahead of the stock market itself. Granted, they also put the similar hedges on in the SP500, but the SP500 is an imperfect hedge. The derivative hedges are more directly targeted to the risks the deer and antelope need to hedge most. Therefore it bears close watching to know specifically which concerns are the greatest for the insiders.

    Truly, the inside information does not get leaked immediately. For instance, I am an outsider. I have no visibility to and no way to monitor the derivative indexes directly. Hence, I was slow to pick up on the growing risks to the bond insurers losing their AAA credit rating in December 2007. The stories were starting to be leaked in the newswires, but my own knowledge was too imperfect (short on) to understand how important the growing risks were to the broad market. I did not fully begin to appreciate the bond insurer story until the onset of January, as more and more news stories were picking up on the bond insurers.

    The insiders understood the growing risks several weeks ahead of me. That is why, for me personally, my own risk management strategies have to take the info lag into consideration. It informs me not to take a step back and not stand as close to the fire as insiders do. Because they have visibility and transparency, they can adjust positions much more more immediately and frequently. This enables them to behave like a scalper in the pit would do back in the days of open outcry: making decisions based on visible order flow that they could read ahead of the public.(this is not investment advice, just personal learning experience)

  27. GloomBoom

    Anyone who makes investment decisions based on this kind of analysis gets what they deserve. Now is the time to wait and be patient. Or you’ll be a patient.

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