VIX Below Lehman Bankruptcy Level Leaves ‘Wall of Worry’ Intact

By Jeff Kearns

June 30 (Bloomberg) -- The drop in the Chicago Board Options Exchange Volatility Index below its level when Lehman Brothers Holdings Inc. collapsed leaves the benchmark gauge of U.S. options prices 26 percent above its average.

A four-month rally in equities pushed the VIX to 25.35 yesterday, down 37 percent for the year and giving it the first close below 25.66, the level before Lehman filed the biggest- ever bankruptcy on Sept. 15, 2008. The index has declined 69 percent from its record of 80.86 on Nov. 20, 2008.

Above-average volatility shows traders are still paying up for insurance to protect against losses in the Standard & Poor’s 500 Index. More gains depend on investors overcoming the remaining skepticism, sometimes called the “wall of worry,” spurred by last year’s 38 percent slump in the equity index, the steepest since 1937.

“It’s still elevated because people aren’t 100 percent sure this is all over,” said Stefen Choy, founder of Livevol Inc., a San Francisco-based provider of options market data and analytics. “Everyone is waiting because they know the worst is over, but they don’t know how fast the recovery is going to be.”

The VIX slipped 2.2 percent to 25.35 yesterday. The S&P 500 added 0.9 percent to 927.23, extending its best quarterly advance since 1998, as energy producers gained with the price of oil. The benchmark index for U.S. equities has climbed 37 percent from a 12-year low on March 9 on speculation that the first global contraction since World War II is easing.

Signs of Recovery

In the U.S., the Conference Board’s measure of leading economic indicators increased in April for the first time since June 2008 and rose again last month. Analysts covering S&P 500 companies boosted 2009 profit estimates for the first time this year in May, weekly data compiled by Bloomberg show.

Lehman, once the fourth-largest U.S. securities firm, filed the largest bankruptcy in U.S. history on Sept. 15, prompting a freeze in credit markets. The VIX surged 24 percent to 31.70 that day.

The VIX averaged 20.18 in its history stretching back to the start of 1990 before yesterday. After peaking in November, it dipped below 30 in May for the first time in eight months. The index reached an intraday record of 89.53 on Oct. 24.

The stock market has slumped in the past when the VIX traded at this level. It closed at 25.95 on June 15, 1998. The S&P 500 retreated 11 percent in the next 2 1/2 months as Russia’s debt default and Long-Term Capital Management’s failure caused losses at financial firms. The VIX stood at 25.47 on March 30, 2000, as the Internet bubble was bursting in a collapse that erased 49 percent from the benchmark index for U.S. stocks through October 2002.

Smaller Swings

The VIX is also dropping because stock-market swings are decreasing, which means dealers aren’t able to charge as much for contracts. Twenty-day historic volatility, a gauge of past price swings, for the S&P 500 has declined from this year’s peak of 50.36 on March 24 to a nearly 10-month low of 19.61.

“Option market makers have to maintain option prices at a level that reflects the actual volatility of the market,” said Dan Hutchinson, head of derivatives at Meridian Equity Partners Inc. in New York.

In February, Congress approved a $787 billion economic stimulus plan to help jump start growth and end the longest recession since World War II.

Federal Reserve Chairman Ben S. Bernanke has made unprecedented use of the central bank’s powers as the lender of last resort. He kept banks liquid by accepting bonds they can’t trade as collateral for Treasuries and bailed out the nation’s biggest insurer, American International Group Inc.

“Fear of the doomsday scenario has definitely subsided,” said Jeremy Wien, a VIX options trader at Societe Generale SA in New York. “Given the steps the government has taken and the decrease in huge market swings, it’s entirely reasonable for the VIX to drop to these levels and possibly even lower.”

To contact the reporter on this story: Jeff Kearns in New York at jkearns3@bloomberg.net.