Schaeffer's Trading Floor Blog

How to Make Volatility Work for Your Trading

Examining how realized and implied volatility impacts option pricing

by 6/12/2014 7:57 AM
Stocks quoted in this article:

As we mentioned last week, the CBOE Volatility Index (VIX) is wildly overpriced, even at a full of 11. That's because the 10-day realized volatility (RV) in the SPDR S&P 500 ETF Trust (SPY) and the S&P 500 Index (SPX) is hovering below 5.

Of course, realized vol. looks backward, and implied volatility (IV) prices forward. So, just because the rearview shows that buying 11.5 implied volatility probably lost money for options owners, it doesn't mean that buying options right here, right now will not work. It's certainly a historically low ebb in options volatility, but it will take quite a pick-up in actual volatility on the ground to make it work. RV would have to "rally" about 250%! Even if you prefer to use absolute numbers to compare IV to RV (and you generally should use absolute numbers, in my humble opinion), RV needs to lift 7 points or so. Over the course of forever, IV typically prices about 4 points above backward-looking RV, so we're still a little "fat" at 11.5 vol.

But anyway, you no doubt know all this. It got me curious, though. How does RV look versus IV in other spots? Well, here's a sampling of some big exchange-traded funds (ETFs) and prominent stock names. It's a snapshot of 10-day realized volatility vs. 30-day implied volatility from yesterday morning. I compared them both in percentage and absolute terms.

10-day realized volatility versus 30-day implied volatility

Now, keep in mind there are often company-specific factors that make these comps meaningless in individual names. If earnings are on tap, we'd expect implied vol. to trade at a large premium to realized vol. If earnings just happened, and the stock gapped, then IV is likely at a big discount to RV, et al. It makes the comp the definition of apples to oranges.

We can see the same effect in index and bond ETFs around Fed decisions.

But, having said that, we're in a pretty news-free window right now. Earnings are far enough away on both sides that this is a decent time to snapshot everything and take a gander.

And hey, the SPY and the PowerShares QQQ Trust (QQQ) do stand out in percentage terms. But, it's really not a big deal in absolute terms. If realized volatility ticks up all the way to 8 the VIX would look pretty fair. And, an 8 volatility implies the market has about a 0.5% range on a typical day. It's not exactly a high bar; it exceeded it yesterday, for example.

On the surface (no pun intended), Microsoft Corporation (NASDAQ:MSFT) options look relatively cheap by this metric. A 17 realized volatility is pretty average in here over the course of time. Owning MSFT paper won't bankrupt you here, but it's not likely to make you much money, either. That's because you'd likely have to sit there and tediously flip stock in a tight range. MSFT has basically traded between $38.50 and $41.50 for the entirety of the last three months. The biggest risk in selling options is a surprise gap in the underlying, and MSFT looks like about the least likely spot to ever see that. Hence a strategy of selling straddles or strangles -- unaggressively hedging in the stock and collecting time premium -- has likely worked quite well. So frankly, why should MSFT options trade at any sort of volatility premium? They really shouldn't.

On the flip side, Tesla Motors Inc (NASDAQ:TSLA) options sure look fat. Realized vol. has been under the low 20s for about a month, but before that, it bounced up and down in 2014, with highs around 70. They're a little high, but this stock is the anti-MSFT. There's always a tire fire possible around the next turn.

Most everything else is in some sort of middle ground. Everything prices in an uptick in volatility, which does make sense when vol. is this low across the board. The SPY and QQQ really only stand out because of the low absolute value of RV, and nothing more.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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