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The Fear Factor
But volatility。assumptions。are constantly changing for even optionable stock。 Sometimes。this。is。simply the result of a change in the recent volatility of the stock。 Sometimes。it's。in anticipation of an uping event—such as。an earnings。report—that is expected to result in increased share volatility。 And sometimes。it's。the result of intense option buying prompted by greed or； more often； fear。 Fear is。a potentially strong directional clue for the trader。 At Schaeffer’s。Investment Research； an 〃equity VIX〃 is。calculated for every optionable stock。in order to sharpen the focus。on such situations。
Most traders。are probably familiar with the CBOE Volatility Index （VIX）； calculated by the Chicago Board Options。Exchange to measure the implied volatility。of the options。on the S&P 500 Index （SPX）。 The VIX is。often referred to as。a “fear gauge” because a rising VIX is almost always associated with increased demand for index put options。due to increased investor fear of a market decline。 In fact； major spikes。in the VIX have been associated with major market bottoms； as。extremes。in fear invariably indicate massive investor capitulation and liquidation； which denotes。that the selling pressure has。lifted。 Of course； the difficulty。lies。in determining when the fear level has。reached a true extreme； because taking a bullish position before the fear has。truly peaked is。extremely risky and potentially disastrous。
The equity VIX calculated at Schaeffer's。is designed to focus。attention on stocks experiencing unusual swings。in the implied volatility of their options； and； just as。with the CBOE VIX； spikes。in volatility are of particular interest as。a directional indicator for stocks。 No stock。in recent years。has。provided traders。with more in the way。of volatility spikes。than General Motors。（GM）。
The next major spike in GM option volatility occurred in the second quarter of 2005； as seriousncerns。about the pany's。financial viability。began to reverberate through Wall Street。 Huge positions。in long…term GM puts were being accumulated； some as。outright bets on the pany's。demise and some as part of hedged positions。with GM debt。 Acpanying this。volatility spike was。a pullback。in GM shares to the 25 area； a level not seen since the major bottom in the second half of 1992 （see Figure 7。6）。 The stock。lifted off these long…standing support levels； and by July 2005； it had rallied by about 50 percent to just shy of 38。
Thisbination of a pullback。to a well…defined support level and an extreme in investor fear as。evidenced by a major volatility spike created a good buying opportunity for nimble contrarian traders。
In terms。of the bigger picture； the GM story illustrates。the pitfall of trading oil sentiment extremes—that is； taking a bullish position before the true peak in fear。 Figure 7。6 shows that GM's。share price proceeded to get cut in half during the six months。following July 2005； to a low of 18。33 by year…end 2005； while a spike in the VIX for GM fortably exceeded the second…quarter 2005 spike （sec。Figure 7。5）。 By the start of 2006； the chances。of a GM bankruptcy had reached coin flip levels； according to many analysts。
By February 2006； a mind…boggling three million put contracts。had been accumulated on GM； equal to 300 million shares； or more than half the pany's。outstanding shares。 Of course； most of these options。were out of the money so thisparison is。somewhat misleading。 Still； the sentiment on GM in the options。market was。extremely bearish； whether measured by put/call ratios； the intensity of put open interest； or by option volatility levels。
The Contrarians Weigh。In
But sometimes。the strongest confirming evidence that the bottom is。truly in place es。from outside the quantitative world。 From a contrarian perspective； this。evidence arrived in the form of a cover story on GM in Fortune magazine by Carol Loomis in the issue dated February 20； 2006。 Below is。an excerpt from my mentary of February 13； 2006； on SchaeffersResearch regarding thisver story：
It is。the instinctive wish of most American businesspeople； even those unlikely to be directly。affected； that General Motors。not go bankrupt。 True； some people will say； 〃They had it ing to them；〃 But the majority will be more practical； telling themselves。that the pany is。so central to the economy； so sprawling in itsmercial reach； that bankruptcy—〃going into chapter〃 as。restructuring folks say—is。ominous。almost beyond contemplation。 And yet the evidence points； with increasing certitude； to bankruptcy。 Rick。Wagoner； GM's。53…year…old chairman and CEO； may say； as。he did in a January interview with Fortune in his。aerie of an office high above the Detroit Rivet； 〃I know that things。will turn around；〃 But he cannot know that。 He may not； deep down； even believe it himself；
— （“The Tragedy of General Motors；” Fortune； February 20； 2000）
Schaeffer's。addendum （February 13； 2006）： The words quoted above were emblazoned on the cover of one of Americas。most popular business publications。 It is。the second major negative piece on General Motors。from Fortune in less。than a month （〃Detroit's。Endless Winter；” January 30； 2006）。
I point this。pattern out not to proclaim that GM does。not have the problems。that have been well documented in these articles。 But I'll also note that； in my opinion； there is。absolutely。nothing that was。revealed in this。somber and extensive cover piece that has。not been thoroughly documented and discussed on numerous。occasions in numerous。other media forums。
Calling a bottom in a troubled pany is。always。supremely difficult （I've been thus。far way too early ＇read： “wrong”＇ in calling one for GM）； as。much of the negative sentiment is。well deserved and the weak price action does。not provide the 〃contrarian contrast〃 between negative sentiment and strong technicals。that is。at work in the best of contrarian buy situations。 It is。only when the sentiment bees。over…the…top gloomy and almost inescapable in its。pervasiveness。and totally dismissive of current and potential positive developments。that one can feel somewhat safe in making the bottom call。 And I think with the arrival of this。latest GM cover story； we’re there； just as。we were in November 1992； when Time magazine’sver asked； “Can GM Survive in Today's。World？〃
This。does。not mean that GM stock has。no additional downside。 It is。certainly possible； even if bankruptcy were not at all a concern； for the shares。to retest the recent lows in the 18 area。 And one cannot pletely rule out the worst case。 But investing is。a probability game and a game of paring potential rewards。and risks； and in GMs。case here and now。 I believe the potential upside is。well worth the risk of the potential downside。
The Volatility Payoff
If an options。trader takes。away just one concept from this。chapter； it would be the following： When buying options； the trader pays。for volatility but the payoff is。in directional price movement。 In other words； options are priced from a statisti…
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But Harley…Davidson call buyers。received a double benefit： They paid relatively little for their options because of the stocks。modest volatility and their payoff was。huge on the big rally in the shares。
The point here is。that there is。a sweet spot for the option buyer—a period during which volatility is low； option prices。are cheap （due to the low volatility）； and directional movement is。robust。 Steady…as…she…goes。rallies。such as。that experienced by Harley…Davidson in Figure 7。8； perversely。enough； register as。a low volatility input to the option pricing models； which then spit out low option premiums。 In such an environment； the leverage offered to option buyers。for the risk。they assume increases substantially； often skewing the risk…reward equation dramatically in their favor。
In the Harley…Davidson example （assuming a 25 percent annual volatility）； a six…month； 50…strike on…the…money call option would have been priced at about 3。50 when the shares were trading near the 50 level in June and July 2006。 Harley…Davidson proceeded to trade as。high as。75 by November 2006 （see Figure 7。8）； and this。50…strike call option would have had a value of 25 （75 …50） at that time。 The call buyer thus。achieved a profit of 21。50 on a 3。50 investment； for a 611 percent gain； and the options。leverage in this。example on the 50 percent gain in the stock。was。12。3 to 1 （614 percent 50 percent）。 But if the options。on Harley…Davidson were priced at the 40 percent volatility level （parable to those of Schlumberger during this。period）； this。leverage would have been significantly。reduced to about 7。5 to 1。
Before the Storm
But does。the fact that low volatility can turbo charge the leverage of option buyers。have significance for the stock。trader？ It does。in the sense that major troughs。in volatility are often a signal of the calm before the storm； the storm being a major directional move for an asset。
A funny thing happened in July 2006 as。crude oil futures。（CL/） were pushing through the 80 mark。amid talk。of ever…rising energy prices—the four…week。historical volatility for crude oil reached a three…year low （see Figure 7。9）。 In fact； crude oil volatility。had declined by 60 percent from its pi