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VIX and Put Options
By David Krein |

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The favorable performance of major equity indexes in 2006 has given investors a lot to be thankful for, and a lot to think about going into 2007.

For those that have protecting their capital and capital gains at the top of their priority list, the final half of the final month of the year seemingly brought a substantial gift - we observed some of the lowest VIX readings on record.

The VIX

The VIX is designed to serve as an aggregate measure of implied volatility. The reading is derived from a subset of S&P 500 options, using prices on the two nearest expiration months. However, this measure is not necessarily representative of the real-world costs that investors might face when considering and implementing a portfolio protection program - especially for a specific portfolio.

Therefore, it can be a useful exercise to map and monitor how the VIX relates to real-world costs for a specific portfolio program. There is no single approach for all investors, of course, but one possible starting point is to evaluate option price levels under the current VIX regime.

Let's look at the market for put options on major equity indexes. Specifically, let's examine offer-side prices from the Chicago Board Options Exchange (CBOE) on the last day of trading in 2006. The data are presented in the form of annualized premiums as a percentage of underlying index value for select out-of-the-money strikes. This summary is intended to allow for easy cost comparison across maturities and strikes for the underlying index that might best match a particular portfolio. (Of course, this process can be carried over to any underlying index.)

By normalizing the actual out-of-pocket option expense (as opposed to implied volatility) for a given level of protection, we can ultimately guide the selection and timing of a specific portfolio protection strategy by using the VIX as the rule-of-thumb.

An excerpt of SPX (S&P 500) data can be found below or here.

	Mar 07	Jun 07	Sep 07	Dec 07	Jun 08	Dec 08	Dec 09
1,100.00	0.20%	0.50%	0.60%	0.60%	0.70%	0.70%	0.80%
1,200.00	0.60%	1.00%	1.20%	1.20%	1.20%	1.10%	1.10%
1,250.00	0.90%	1.50%	1.60%	1.60%	1.50%	1.40%
1,275.00	1.30%	1.80%	1.90%	1.90%	1.70%	1.60%
1,300.00	1.70%	2.20%	2.30%	2.00%	1.90%	1.70%	1.60%
1,325.00	2.30%	2.70%	2.70%	2.50%	2.10%	1.90%
1,350.00	3.30%	3.40%	3.10%	2.80%	2.40%	2.10%
1,375.00	4.60%	4.10%	3.60%	3.20%	2.70%	2.30%
1,400.00	6.30%	5.00%	4.30%	3.70%	3.00%	2.60%	2.10%
1,425.00	8.90%	6.20%	5.00%	4.20%	3.30%	2.80%

An excerpt of RUT (Russell 2000) data can be found below or here.

	Mar 07	Apr 07	Jun 07	Sep 07	Dec 07	Jun 08	Dec 08
600	0.40%	0.60%	1.00%	1.20%	1.40%	1.50%	1.50%
650	1.00%	1.50%	1.90%	2.20%	2.20%	2.10%	2.00%
700	2.90%	3.40%	3.60%	3.50%	3.40%	3.00%	2.70%
750	7.20%	6.90%	6.40%	5.60%	5.00%	4.10%	3.60%

An excerpt of NDX (Nasdaq-100) data can be found below or here.

32	7-Jan	7-Feb	7-Mar	7-Jun	7-Sep	7-Dec
1,300.00	0.40%	0.30%	0.20%	0.70%	0.90%	1.10%
1,400.00	0.40%	0.40%	0.70%	1.40%	1.50%
1,500.00	0.40%	0.80%	1.50%	2.30%	2.50%	2.30%
1,550.00	0.50%	1.30%	2.10%	3.00%	2.90%	2.70%
1,600.00	0.70%	2.10%	3.50%	4.00%	3.60%	3.50%
1,650.00	1.70%	3.90%	5.50%	5.20%	4.80%	4.20%
1,700.00	5.40%	7.10%	8.60%	7.40%	5.80%
1,750.00	15.20%	13.20%	12.40%	9.10%	7.00%	6.40%

The immediate point of interest revealed by these charts is that the out-of-pocket expense for portfolio protection can vary dramatically depending on the underlying, strike, and maturity of the contract. Identifying the optimal combination to best fit within a portfolio's risk tolerances and budget can be a moving target, especially as these factors vary with time.

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