Schaeffer's Outside the Box Blog
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Well, we’re going to have a new weekly feature for you here in the Outside the Box blog. We’re going to regularly look at historical volatility (HV) vs. implied volatility (IV) in a variety of names, and do our best to ascertain whether there’s a trading opportunity there.

Let's get a big disclaimer out of the way first, though: It's not, not, not an arb trade. If the IV of an option is way below (above) the HV of an option, it does not necessarily mean that the option is a raging buy (sell). That’s for the very simple reason that IV prices forward and HV looks backwards.

Say XYZ has earnings due soon. Implied volatility in XYZ will anticipate a potential gap in the stock, and will likely trade "fat" relative to the HV over any timeframe. Once earnings come out, IV will tank, while HV will possibly rise -- or even explode, if there’s a large move. Thus, the relationship will invert, but it doesn’t mean options are cheap.

That does not mean there’s no value in the comp, though. That’s just the extreme example of disparity, but there are plenty of little ones as well. The idea is to look into them and see why we have the disparity, and whether there’s potential opportunity.

And right off the bat, we have a doozy of a disparity, and it's in our good friend the CBOE Market Volatility Index (VIX). Options on the VIX, that is.

The VIX itself is all over the place lately. It shot up to 23 last Friday, and then plunged all the way down near 14 by Thursday. That’s six calendar days, but only two trading days, and HV calculates in trading days. Needless to say, it caused a spike -- 10-day HV in S&P 500 Index (SPX) was 78 on Dec. 27; by Jan. 3 it was over 197.

Options on VIX moved the other way: 30-day IV in VIX peaked at 106 on Dec. 28, but it was in the mid-70’s by Jan. 3.

So, there’s your disparity. Options trading at a 74 vol. with the index moving at a 197 vol.

Are options in VIX a buy? Specifically, VIX calls into the VIX dip?

I could make a case to buy them directionally. Whereas VIX itself was way overbought on Dec. 28, it moved quickly to oversold. It's now about 18% below the 10-day simple moving average. The problem is you're buying options on VIX futures, not VIX itself. And VIX futures did not move quite as much as VIX (hat tip to Mark Sebastian for reminding me of this). February-dated options traded at a discount to VIX at the VIX peak last Friday; now they trade at over a $2 premium, which is basically fair and normal.

I can’t get an HV reading on VIX futures, but I can get one on iPath S&P 500 VIX Short-Term Futures ETN (VXX), which proxies a hypothetical, rolling 30-day future. And 10-day HV in VXX has spiked, but "only" to about 107. So, VIX options are not quite the huge discount when viewed in that light (call it a Grande discount, down from Venti discount).

What’s more, the dip in IV in VIX is a little misleading in and of itself. VIX options have a positive skew, meaning that the lower the strike, the lower the IV. In English: VIX February 16 calls trade cheaper in IV terms than VIX February 20 calls, which in turn trade cheaper than VIX February 24 calls, which in turn trade cheaper than… well, you get the point.

Since the IV calculation weights near-the-money options much higher than out-of-the-money options, a drop in VIX itself to a lower strike will lower an index of IV on VIX options in and of itself.

So (really), long-story short, this is superficially a humongous disparity. But a look under the hood suggests the vol. of VIX itself overstated the actual vol. on "Trading" VIX. And the dip in vol. on VIX options overstates the actual selloff in VIX options. Going long vol. here, or at least covering a volatility short, does make sense directionally, in my humble opinion, but VIX options don’t represent a spectacular deal in any way, shape or form.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.

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