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ETF Specialist

Is Volatility Cheap Yet?

The VIX has fallen, but waiting for the next spike could be painful.

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The positive surprises of second-quarter corporate earnings seem to have taken the edge off the stock market that persisted even through the rally of March through June. Even as the S&P 500 soared from 667 to 950 in the second quarter, no one quite seemed to believe it could stay so high, and widespread nervousness showed up in the daily articles predicting a double-dip recession.

That nervousness also expressed itself in options prices, which serve as a barometer of investor sentiment due to their ability to serve as portfolio insurance. Since put options guarantee a minimum price for their purchaser on a given stock or index, put option prices rise significantly when investors fear that prices could fall. Higher options prices thus predict that their underlying index will be more volatile, or more liable to large jumps in the future. Using some rather abstruse mathematics, it is possible to back the implied volatility out of a series of options prices to figure out how much market movement investors currently fear. This is precisely how the widely known VIX index (or "fear index") is calculated, using prices for the frequently-traded 1-month options on the S&P 500 Index.

Bradley Kay does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.