Ready! Set! ...Go Back to Sleep

	Bernie Schaeffer Schaeffers Research.com
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If there is a poster child for how option selling has sucked the life out of volatility in this market across the board, it would be in the price action of Dell last Friday.

Before reporting earnings on Thursday evening, Dell had been exhibiting a very modest annualized volatility of about 15 percent this year, with (you guessed it), sideways price action.

The company's earnings and outlook after the close on Thursday seriously disappointed, and the shares plunged by almost eight percent on Friday. To put the magnitude of this eight-percent single-day move into perspective, Dell's "normal" volatility of 15 percent would lead one to expect 99 percent of its single-day moves to be within three percent of its prior day closing price. Of course, volatility after earnings is always prone to a bulge, but this was still a huge move.

Yet take a look at Dell's intraday price action below. After a huge gap down on Friday, the shares began a gentle recovery and then proceeded to flat line for the entire afternoon.

What's going on here? Two things, as I see it.

1. Inside-out investor psychology - For decades of stock market history, investors have reacted to earnings-driven, single-day share plunges by raising their perception of the risk of holding that stock for fear of additional downside. Selling would beget more selling. These days, there is a "reversion to the mean" mentality. The thinking after the Dell debacle becomes something like this: "Dell is back near the low end of its range for the year, so downside risk is low."
2. Inside-out options-trader psychology - Not too long ago, a similar plunge would have created aggressive demand for put options out of fear that the stock was going to continue to implode. On Friday, there was huge demand from sellers of Dell's September 37.50 calls (DLQ IT). In other words, an eight-percent, single-day hit in what had been considered a "safe" stock is now viewed as a reason to sell volatility! In addition, a "feedback loop" is now being created, whereby the accumulation of Dell options by sellers will have the effect of further dampening Dell's volatility.

How long can investors and option traders continue to behave irrationally? The shift back to normalcy will probably take way longer than sane people can reasonably tolerate. But at the same time, I believe the day of reckoning is close enough that those who have learned to routinely reach out to catch falling knives can begin to wear "Dead Man Walking" t-shirts.

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