NEW YORK (CNN/Money) - Signs that investors have got a bit too enthused lately abound, if you go looking for them.
There's a surge in online trading, there's big volume in penny stocks, there's the way people have piled right back into the same stocks that gave them so much grief last time. And then there is the way that what is called implied volatility -- a time-honored measure of the degree of fear in the market -- has crashed to a level not seen in over five years.
What implied volatility really measures is how much of a premium investors are willing to put on options, which give them the ability to buy (call options) or sell (put options) a stock or index at a set price. The more options cost, the more investors expect prices to move. Hence implied volatility -- which differs from actual (or realized) volatility.
The favored way of measuring implied volatility is what used to be the Chicago Board Options Exchange's volatility index, or VIX. (The CBOE rejiggered it recently, so now we watch the old VIX while we wait for the new one to get a bit more history behind it.) In recent years, whenever the VIX fell below 20, Wall Streeters would start to worry that investors weren't worrying nearly enough -- and that the market was vulnerable as a result.
The VIX hasn't been above 20 since November. Friday, it closed at 14.87, the lowest it's been since April 1997.
But here's where it's important to remember that what the VIX really measures is what options cost -- not fear and not even, when it comes down to it, how volatile investors think the market is going to be. Because it turns out that there is a big factor that could be pushing options prices: A big jump in the issuance of convertible bonds.
Convertible bonds are bonds that give investors the option of converting them into stocks at a predetermined price. Put the emphasis on "option" -- they are, in essence, not all that different from call options. Low interest rates have made them a favored method of raising capital among companies in recent years and investors who like their yield characteristics have been gobbling them up.
In 2003, according to Thomson Financial, convertible issuance skipped up to $96 billion from $60 billion in 2002. There is, as a result, a bigger supply of call options floating around the market. When supply rises, prices fall. This pushes the VIX lower.
Makes sense, but is it true? Let's take a look at another options-market measure of sentiment -- the put/call ratio.
Puts are bearish bets, giving investors the option to sell; calls are bullish bets, giving them the option to buy. The CBOE's put/call ratio has been hanging around 0.7 lately -- low relative to where it's been over the past couple of years, but nothing close to the 0.4 it dipped to as the Nasdaq peaked in 2000.
It seems like the only way to square the divergence between the VIX and the put/call ratio is to say that there must be some other influence at work. Heavy convertible bond issuance fits the bill. We're left thinking that the VIX is saying investors are far more complacent than they really are and, conversely, that the put-call ratio may be understating how bullish they've become.
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