Did the Thanksgiving Rally Start Late, or Did Santa Come Early?

Yesterday’s 490-point rally in the Dow Industrials was quite a change of pace after the worst Thanksgiving Week market since 1932. To say we didn’t get a Turkey Day rally is an understatement. However, yesterday stocks surged as the Fed, the European Central Bank and other central banks around the world decided to join forces and inject liquidity into the markets.

But will this market euphoria last, or did we simply get our Santa Rally early (or is this our Thanksgiving run-up, just a week late)?

Trend-following strategists have gotten chopped up worse than the Philadelphia Eagles pass defense this fall. And most reversals have come this way, via steep morning gaps. Which of course means that stops have limited value as protection for overnight positions.

The volatility markets didn’t particularly believe in the sell-off last week. The CBOE Volatility Index (CBOE:VIX) rallied about 7%, but that was a significant underperformance with the market drifting nearly 5% — especially given that the VIX has hovered in the low 30s for most of the month of November.

The Thanksgiving Market Slump
Might Offer a Preview of December

Now, part of that had to do with the calendar. Option market-makers lower their bids ahead of and into slow holiday weeks on the (generally correct) assumption that realized volatility slows. And indeed, realized volatility has slowed.

Realized volatility in the S&P 500 sits near 20, so a VIX near 30 actually overprices options relative to the pace the market is actually moving now.

This whole setup is not unusual. I ran numbers for my book, Options Volatility Trading (shameless plug alert!) and found that options in the December cycle are the most overpriced of the year.

I defined this as the relationship of median implied volatility (basically the VIX) to the median realized volatility of the cycle. It came out to 1.66, which is pretty close to the ratio we’re seeing right now.

Can the Markets Make Sense
of All This Mayhem?

Volatility often picks up in the fall, and then tapers off into year-end. Options lag a bit in picking this up, and thus they stay modestly overpriced into year-end.

Will it play out that way this year? We never know of course, but it seems like a plausible setup.

Headline risk remains a factor. As we’ve seen, the markets just cast their approval of the latest lifeboat being tossed to the Titanic that is the Eurozone debt problem, and yet no one is looking at solving the financial problems in the United States!

So, the question is to what extent the market has already priced in the next events to unfold, whatever they may be. It’s possible we’ve already discounted them, but only time will tell.