Schaeffer's Trading Floor Blog

Why Perspective Matters When It Comes to Volatility

Our low-volatility environment makes even small increases in volatility hard to bear

by 7/10/2014 7:47 AM
Stocks quoted in this article:

It's easy to sit here and make fun of everyone freaking out and calling tops on the slightest uptick in volatility. But in the interest of fairness, I should point out that there's some merit in reacting to upticks in volatility, even from depressed levels.

Volatility is a user-friendly translation of standard deviation. We can convert it to a typical range in the underlying, either in percentage or absolute terms. The easiest way to do this is to use the good old "Volatility Rule of 16." An implied volatility (IV) of 16 prices in about a 1% range in the underlying on an average day. An IV of 32 prices in a 2% range, an IV of 8 prices in a 0.5% range, etc.

Right now, the CBOE Volatility Index (VIX) is near 12. So traders in SPDR S&P 500 ETF Trust (SPY) and S&P 500 Index (SPX) options are pricing in about a 0.75% range on a typical day. That's a little under $1.50 in SPY futures, or $15 in SPX futures.

What happens if the SPY or the SPX has a wider range than that? Well, a standard deviation really says that about two-thirds of the observations will be within that range, so let me put it another way. What happens if we start seeing a series of days outside that range? Quite simply, it's not factored into the pricing. Options shorts start feeling squeezed and are forced into some combo of lifting their own offers, chasing the underlying or buying options. And this dynamic is the same whether it occurs from a low-volatility base or a high-volatility base. All that matters is the degree to which the options price in the resulting volatility.

And that can't help but color our perceptions of the underlying action. Ten-day realized volatility in the iShares Russell 2000 Index (ETF) (IWM) was as low as 7 a couple weeks ago. Now it's in the 14s. That's still not a high reading, but it doubled in a couple weeks, which does make it at least feel like we're in a risky environment.

I always like weather analogies when it comes to options pricing. So think of it this way: That 7 volatility was the equivalent of a seasonably hot and humid summer day. Now the humidity dissipates, the temps go down, and it's 70 degrees. By any rational standard, that's calm and comfortable weather. But coming off a beastly hot and humid stretch, it will probably feel kind of chilly.

It's all perspective. Fourteen volatility in the Russell 2000 Index (RUT) is pretty much nothing in fact, it's on the low end. But coming off historic lows, it makes it feel a bit scarier than it would normally feel.

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

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