Schaeffer's Trading Floor Blog

The Backward-and-Forward Volatility Game

Exploring the inflated VIX premium compared to historical volatility measures

by 6/5/2014 7:17 AM
Stocks quoted in this article:

Why is the CBOE Volatility Index (VIX) so high?

I mean, seriously. After all, 10-day historical volatility (HV) in the SPDR S&P 500 ETF Trust (SPY) is 4.7 as I type. It's the purple line on the graph below.

Daily chart of SPY since January 2014
Chart courtesy of TD Ameritrade

The VIX is near 12. That's about a 250% premium! Even if you prefer to compare them in absolute terms (as you should, in my humble opinion), that's still a 7.3-point premium of implied over historical. Normally, we see about a 4-point premium.

So sell all options, right?

Well, if only it was that simple. Remember always that historical volatility looks backward and implied volatility looks forward. And right now, the market is looking forward to whatever Mario Draghi has to say. He probably already said "it" by the time you read this. These "biggest European Central Bank announcements ever" seem to happen as frequently as our "biggest Fed decisions ever." By the time the ink dries, we start anticipating the next one. But hey, whatever, volatility is hurting right now and it's almost summer.

Remember also, that VIX is pretty near a floor. It can probably get to very high single digits, but we're not too far away from that. Historical volatility simply can't get much lower. A reading of 4.7 implies a range in SPY or the S&P 500 Index (SPX) of about 0.3% on a typical day. Even the slowest of days manage at least that. In other words, that 4.7 is unsustainably low over time, so it's safe to pay an above-normal premium for options, even in the absence of expected news.

In other words, I'm sure there's some ECB premium in options now, but not an enormous amount, mainly because VIX can't really drop much from here.

What 10-day realized volatility does tell you is how options ownership fared over the past two trading weeks. And the answer is that it fared quite poorly. If you bought options at the equivalent of "cheap" 11.5 implied volatility and attempted to offset your daily decay with some stock flipping … well, most likely it wasn't a great trade.

"Cheap" didn't fare well looking backward, but no way to know how it fares going forward. The only thing you can say is that the more realized volatility stays in the tank, the less inclined the masses will be to pay much for options going forward.

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

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