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Oct. 10, 2012, 11:42 a.m. EDT

Is it time to short volatility?

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About Andrew Giovinazzi

Andrew Giovinazzi was a member of both the Pacific Exchange and the Chicago Board Options Exchange where he made markets in both equity and index option classes. During that period he never had a down year. In 1991, Andrew started and ran the Designated Primary Market Maker post for Group One, ltd in Chicago. In 2001, he co-founded Henry Capital Management. He became Chief Options Strategist and Option Pit Mentoring in the Fall of 2011. Andrew has a Bachelor's degree from the University of California, Santa Cruz in Economics. /conga/trading-deck/bios/giovinazzi_andrew.html 230100
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By Andrew Giovinazzi

Is it time to short volatility?

Now that the euro is temporarily safe from destruction, my mind wanders to the reasons why both the euro and the U.S. equity markets can spiral into a decline. Most of the downward momentum is based on things that might happen, as in Apple (AAPL) earnings will be awful (AAPL from $700 to $625 over the last two weeks), the IMF declares the world economy could slow down (this is news to the central banks that are lowering rates) and U.S. earning season is around the corner, and it will be awful, too. That makes a big bunch of awful when nothing has really changed fundamentally for the worse.

As an observer of market volatility, I am more concerned about a change in perception. Worry and market strife are a constant factor for equity investors. Where do you see that? The most direct place to find an inflection in perception is in the SPDR S&P 500 ETF Trust /zigman2/quotes/209901640/composite SPY -0.49%   skew. Index volatility offers the rare bird in a market filled with talking heads as the unbridled opinion of hundreds of thousands of market players. Are people freaking out? Just check the implied-volatility skew in the SPY.

What the heck is the skew you ask? It is just the difference in implied volatility in each strike of the index of choice. Right now the November skew in the SPY is touching the high bounds of worry given the at-the-money volatility. Now my readers ask how I know this. I watch relative fluctuation in implied volatility every day.


3D Volatility Charts from ORATS/Aqumin

By following the link above, you see a 3D representation of implied volatility in the SPY. Each little spike is a strike and an implied volatility value (call next to put). The color represents the how much the value is jumping above the norm. As you can see from the snapshot, the November (highlighted option chain) downside is jumping (dark green) and the November upside volatility (dark red) is retreating. The market is more worried about the downside than the upside in the November cycle. That was not true a week and half ago.

There are a couple of pieces to this puzzle. AAPL running around is having a big impact on implied-volatility perception. The market has run up a bit and news-weary watchers are waiting for the next shoe to drop. While all of this is cause for concern, I am of the mind to fade an extreme, and when volatility starts to bid like this, I become skeptical. Alcoa /zigman2/quotes/200686102/composite AA -4.48%  earnings just came in and were not a disaster, and my feelings on this earning cycle will be the same.

The easiest way to fade an overreaction in volatility is to short the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN /zigman2/quotes/202248173/composite VXX +0.70% . My favorite way to do that this year is to buy out-of-the-money put time spreads on the product. Buying 2 VXX Oct/Nov 33 put time spreads provides short exposure to market volatility for just the risk in the spread and the position produces positive decay.

Disclosure: Mr. Giovinazzi has positions in the VXX.

US : U.S.: NYSE Arca
$ 431.24
-2.14 -0.49%
Volume: 149.88M
Jan. 27, 2022 4:00p
$ 58.03
-2.72 -4.48%
Volume: 6.45M
Jan. 27, 2022 4:00p
P/E Ratio
Dividend Yield
Market Cap
$11.37 billion
Rev. per Employee
US : U.S.: Cboe BZX
$ 24.49
+0.17 +0.70%
Volume: 120.74M
Jan. 27, 2022 4:00p

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