What Are Option Prices Really Telling Us?

Option prices may not be underpriced after all

by Adam Warner

Published on May 7, 2015 at 7:45 AM

We're smack in the midst of our (seemingly) weekly bout of extreme market ugliness. Could this be the "Big One"? Is it the time to back up the volatility truck? This, from CNBC:

"Options expert Dennis Davitt says he's never seen a better time than now to buy portfolio protection in the form of options.

'Markets are poised to explode like an over-compressed spring,' he said. And yet 'options are very inexpensive.'"

OK, sort of agree with the "over-compressed spring" part. Bollinger Bands are a good proxy for compressed, and as we noted the other day, they've gotten relatively tight. And we've hovered within a small-ish range for the entirety of 2015. That's not going to persist forever, so I don't disagree with planning for that inevitability.

But I'm not sure "options are very inexpensive." I mean, now, they're really not -- we're hovering at "overbought," as defined by CBOE Volatility Index (VIX) 20% above its 10-day simple moving average. This interview was before that, though, so let's talk in absolute values instead.

Yes, VIX in the 12-15 range is on the low end. Unfortunately, that's a good reflection of our current intermediate-term backdrop. Realized vol sits near 10. Index highs keep holding and every ominous-looking sell-off (so far) gets bought. I can't argue with anyone buying puts here at this volatility -- I just don't believe it's any sort of bargain-basement price. It's fair value for now. If you time a downdraft well, great; I'd just suggest that we've had a bevy of false breakdowns getting to this point, and I'm not sure why it's so different this go-around.

"'There are a ton of crowded trades like short euro and short oil that haven't been working out lately. There's a historic lack of liquidity. Negative rates on long-dated government bonds are increasing the use of leverage in fixed income products, because you have to be levered at these low levels. And utilities and staples are trading at growth multiples,' he said Tuesday in a phone interview with CNBC.

'And yet, options prices at these low levels are telling people, "Everything is OK."'"

Again, I can't dispute anything in there, with the exception of some special value in options now. We're "overvalued," the Fed's going to tighten, and we even have a Fed chair saying stocks are high (although she also said they're not high vs. bonds -- the market's not concerned with that latter part right now). And yet, options are ignoring this.

Are they? That's hard to imagine. Options price in an estimate for volatility going forward, from now until said option expires. To call them underpriced implies that they are not factoring in ... something ... that we don't know about just yet. Well, thing is, we know all this. We know stocks are valued at X times earnings, we know the Fed will tighten someday, et. al.

So I'm not sure options really say "everything is OK." Rather, I believe they say "we know about X, Y,  and Z, just like you," and this is our level of concern. And I just have a tough time saying our current level of concern is so out of whack.

One of these sell-offs will persist. It's four-plus months since our last overbought VIX -- which is on the longer end of normal. So, decent chance this market drop goes further. But if it gets to that point, I'd rather fade and sell volatility than pre-anticipate and buy options paper.

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


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