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Terrorism and Volatility How Threats and Fears Impact Option Premiums

By Scott "The Strategist" Fullman
October 24, 2001

September 11, 2001, was a day that changed the way Americans looks at their jobs, lifestyles, and each other. The violent actions that resulted in the death, injury, and destruction have certainly left their mark, but have also brought a renewed sense of patriotism and resolve. As the country heals and rebuilds, the thoughts of that horrible day remain with us. Television and radio reports continually refresh us with new statistics and events at the site of the Pentagon, and what had formerly been the World Trade Center, as well as with the military and political response to these events. Now the prospects of other forms of terrorism are having an impact, even on our investment decisions and the way that we trade. As a result, option premium fluctuations have increased on every little bit of news related to such events.

Prior to the events of September 11, implied volatility levels for the S&P 100 Index (OEX) and the NASDAQ 100 Index (NDX) had risen to their highest levels since March. This followed a sharp decline for the benchmark measurements during the summer as evidence mounted that the U.S. economy was heading toward recession. During the period between July 2 and September 7, the Dow Jones Industrial Average (DJIA) dropped by 9.3%, the S&P 500 Index (SPX) lost 12.2%, and the NASDAQ Composite Index (COMPQ) fell 21.5%. OEX and NDX lost 13.3% and 25.7% respectively during that same period. However, during that period, investors remained complacent that the market was going to turn positive. Implied volatility levels, a measurement of risk premiums within option contracts, finally began to rise at the beginning of September as fears began to rise that the market was going to continue its downward trend for the foreseeable future. On September 10, the S&P 100 Implied Volatility Index (VIX) rose to an intra-day high of 37.35%, and the NASDAQ 100 Implied Volatility Index (VXN) rose to 66.06%, the highest levels since the summer decline began.

Figure 1 - Daily chart for the Dow Jones Industrial Average (DJIA) and the NASDAQ Composite Index (COMPQ) for the period of June 1, 2001 to October 17, 2001.

The attack on the United States resulted in a four-day closure of the equity markets, the longest since 1933. When the markets reopened on September 17, as anticipated, share prices fell sharply, resulting in significant losses for the widely watched indices and averages. The negative trend continued for the next several days, pushing the Dow to an intra-day low of 8062.40 on September 21. At this time, the implied volatility indices rose to their highest levels in three years. VIX reached an intra-day high of 57.31% and VXN rose to 91.79%, coinciding with the lows for the major market benchmarks. Since that time, volatility levels have declined from those levels but remain significantly above their summertime levels.

Figure 2 - Daily chart for the S&P 100 Implied Volatility Index (VIX) and the NASDAQ 100 Implied Volatility Index (VXN) for the period of June 1, 2001 to October 17, 2001.


Volatility levels are constantly changing. During the trading day, implied volatility levels move higher and lower based on the premiums of their respective options contracts. These premiums are based on what buyers are willing to pay for anticipated movement, which is usually associated with fear. The higher the level of perceived risk, the greater the rise of the premium level. Conversely, when there is anticipation of lower levels of risk, premiums decline. Investors and speculators will normally become most concerned with the markets at the time when they exit, which lifts the perception of risk but is usually coincident with a bottom. On the other hand, investors and speculators typically reach their highest level of comfort when they are fully invested, which is coincident with a top.

You may ask why this is so. Let's examine this a little more closely. If an investor is fully invested in the market, he/she is usually pretty confident that prices are going to rise, and thus will not seek to hedge their positions by purchasing protective puts. This in turn causes the risk premiums or implied volatility levels to decline, based on a decline in demand for those contracts. Since they are fully invested, they are not apt to purchase more shares. If this coincides with other investors' attitudes and positions, there is little demand for stocks. This drop in demand for shares results in a decline in buying pressure. Investors who first purchased shares near their lows may see the decline in momentum and activity as a signal to take profits, thus causing the formation of a top.

As stock prices begin to fall, investors may seek to purchase protective puts. This is especially true if investors believe that the declines will continue. As the level of fear increases, the demand for put protection rises, thus raising the premium and implied volatility levels. The greatest demand for puts usually occurs when the greatest number of people have already sold their shares, creating a coincidence of high premium levels.

So, as you can see, implied volatility readings are contrary indicators. While I have found these levels to be good indicators, they are not perfect and should not be the only basis for acting on a position. Investors and traders can obtain implied volatility levels, on a closing basis, for most stocks and indices using the services of


Nervousness among investors is evident in the options. The level of nervousness can be measured by watching the changes in VIX and VXN. This was extremely evident during the trading session on October 17. Let's take a look at that day to illustrate the changes in volatility levels.

Wednesday the 16th started on a positive note following positive earnings reports and comments from International Business Machines (NYSE - IBM) and Intel Corp. (NASDAQ - INTC). Foreign markets rose on those reports and indications were that stocks in the U.S. would open on a strong note. At 8:30 AM EDT, the futures in the S&P 500, basis December, were up 11.80, and NASDAQ 100 Index futures were up 39.50. This was the most impressive indication that we had witnessed during the past two months. Stocks jumped at the opening, with DJIA rising 100 points in the first half hour. Around 9:50, OEX was near 569, up 5 points from the previous day. At the same time, VIX had fallen to 34.30% from 35.20%. Rumors surfaced that a commercial airliner was hijacked over Europe, combined with comments about the U.S. economy by Fed Chairman Greenspan to a joint Congressional committee, resulting in a significant decline in prices. By 10:10 OEX had fallen to a 3-point deficit and the implied volatility reading rose back to 35.25%, and was still climbing. When it appeared that the rumors were false, buyers cautiously began to purchase shares, resulting in a recovery to 566.47 on OEX. VIX declined back to 34.85%, but remained well above its earlier lows.

Senate Majority Leader Tom Daschle began a press conference during the 10 AM hour. It was confirmed that anthrax had been found in the Senate and that as many as 30 staffers had tested positive to exposure. Prices began to head south and option premiums began to rise once again. There was also talk that anthrax may have been spread through the Capitol building. At the same time, a story surfaced that anthrax was found in the New York City office of Governor George Pataki. These stories received greater attention as the hour went on and prices began to sell off again at 11 AM. By 1:30, OEX was down 6 points and VIX was at 36.41%, a new intra-day high. Nervous jitters waned a bit as the market benchmarks rose slightly. However, implied volatility levels marked time and then began to rise ahead of the next downturn in the market.

As the afternoon progressed, headlines continued to hit the news tape while television and radio broadcasters interrupted normal schedules with breaking news and developments. President Bush held a news conference around 2:45, adding to the information overload. Stock prices resumed their decline, with OEX and COMPQ ending at their lows of the session. Conversely, at the end of the trading session, VIX was at 37.23% and VXN was at 67.11%, their highest levels of the day.

Figure 3 - Intra-day chart for the S&P 100 Index (OEX) and the S&P 100 Implied Volatility Index (VIX) for October 17, 2001.

On this given day of rising volatility levels, the intra-day range of VIX was more than 8%, while the range for VXN approached 6%. This compares with a 2.7% intra-day movement for OEX, a 3.7% movement for DJIA, and a 6.5% movement for COMPQ. This illustrates that the risk perception factor can be as significant as the trading of stocks and the movement of the key indices.

In summarizing our findings, we can state that war and terrorism have quantifiable impacts on the trading of investment vehicles, especially options contracts. While the markets have recovered from their post-attack lows, the additional risk has been factored in the pricing of options contracts. VIX and VXN remain above their respective pre-attack highs, with the gap between those highs and the recent volatility lows indicating the minimum risk variable for those associated indices. The risk-to-reward ratio has been rebalanced for the higher volatility factor.