There is some very interesting and unprecedented action taking place in the options market, at least with respect to volatility. First, some background. There are several indexes that track the implied volatility of index options. The most widely known is VIX which measures the implied volatility of the S&P 500 stock index options.
But what about an index that tells us the implied volatility of the options on the stocks that make up the individual constituent securities? For that, there is no index. Fortunately, I have a pretty extensive option database that allows us to make that calculation every evening. We call this SPXIV. [To calculate SPXIV, we follow this process: 1)We calculate the implied volatility of the at-the-money front-month and next-month put and call options for each security in the index. 2)We use those results to create a rolling 30-day average implied volatility for each underlying. 3)Finally, we add up each underlying's average implied volatility and divide that sum by 500.]
The chart below shows the history of the two different volatility measures. The S&P 500 is in the top window. The two volatility measures are in the lower window: SPXIV is the think line, VIX is the thin line. [As an aside, as the two volatility measures come together, correlation between stocks is expected to rise ... but that's a different subject.]
Click image for enormous chart
What I want to concentrate on is the action on the bottom right section. The chart bekiw zeroes in on that time period.
Two unusual things have happened the last two weeks. First, the market cracked and you got the normal rise in index option volatility as evidenced by the rise in the thin line. But what you didn’t get was a corresponding rise in individual stock option volatility. While it’s normal for stock option volatility to not rise as much as index option volatility in a market drop like we saw two weeks ago, the miniscule rise in SPXIV compared to VIX was even smaller than normal.
But that’s not what really stands out. Since the speed of the decline in the market slowed down last week, VIX dropped quite a bit. Index options got relatively cheaper. That happens. Sometimes the additional decline in the market causes VIX to rise; other times VIX falls because the market’s decline de-accelerates. In this case, the latter occurred.
What was unprecedented is what happened to individual stock option volatility.  During this same time frame,  individual stock options actually got more expensive! That is not normal! Folks, a rise SPXIV during a period in which VIX drops by that magnitude has never happened, at least in our 10+ year database.
Wish I had additional information to tell you what it all means. As it stands, I can only tell you this: I am looking forward to seeing how the situation resolves itself. Perhaps it will amount to nothing. On the other hand …
– Don
Since last October, I’ve seen some very interesting index divergences. This one is even more interesting. The last time I’ve seen as many divergences, would be the period leading up to the 2000 top in stock prices. Let’s hope that this isn’t the case.
All else being equal, as you said earlier this means stock correlation is decreasing. This would read as a rising market no?
Not necessarily. High correlation merely means that all boats are rising with the tide … or falling. For instance, correlation hit it’s highest level ever during the October 2008 meltdown when everything was falling at the same time.
On the other hand, during the summer of 2008, correlation was real low when the commodity stocks were getting slammed and financials were experiencing a temporary respite from the Bear Stearns implosion. That rebound did not last long though.
Point is, think of correlation as a measure of connectedness, not direction.