The VIX and the Psychology of Implied Volatility

The CBOE Volatility Index (VIX) proxies the implied volatility of an S&P 500 Index (SPX) option with 30 days' duration

Sep 4, 2015 at 9:21 AM
facebook X logo linkedin

You probably don't need a weatherman to tell you it's really hot and humid out this week. And you certainly don't need me to tell you it's become very volatile lately. 

But hey, I can help quantify it! So please, allow me to quantify. 

All options trade with an implied volatility (IV). It's essentially an estimate of the realized volatility (RV) in the underlying instrument between now and when the option expires. The CBOE Volatility Index (VIX) proxies the implied volatility of an S&P 500 Index (SPX) option with 30 days' duration. 

IV looks forward and theoretically anticipates future volatility. In reality, of course, it mostly reacts to the most recent realized volatility in the underlying, and projects that that volatility will continue to some extent. 

I say "some extent" because it's a mix of current realized volatility and an assumption of some sort of mean reversion. When RV is very low, options always price in a mean reversion "up." When RV is high, it's the reverse, though not to the same extent.

Some of that is human nature. High volatility is associated with market drops and investor losses. We humans are wired to hate losses way more than we "enjoy" wins, so it's natural that we'd have a stronger reaction when losses start adding up. Implied volatility is more often than not "overpriced" vs. trailing realized volatility, because there are often moments like we see right now and we react strongly to those moments. 

Yada yada yada… We're far enough into the realized volatility spike to look at it a bit.  

Ten-day realized volatility in SPX is now 42. Translated into actual market moves, it means the typical day in the last two weeks has seen about a 2.5% range. In a way, that understates that actual feeling, in that it doesn't capture the swings up and back within that range. 

On Aug. 19, just before this all started, 10-day RV was 10.8. And even that represented a modest uptrend. In May, 10-day RV was as low as 6.7. On Feb. 27, 10-day RV was 4.4. An RV of "8" was more typical for most of 2015, which translates to about a 0.5% SPX move on a typical day. Thus we've pretty much quintupled in realized volatility terms. 

Right here, right now, VIX is underpriced vs. current realized vol. But again, that's expected. It's normal to assume mean reversion. And VIX really isn't at all "cheap" when you consider that's anticipating that a fair price for volatility going forward is about 3x the typical realized volatility we've seen in all of 2015.

Smart guys I used to trade next to swore that the best trading strategy in times like this is to sell "time." The VIX Trading Complex didn't exist then, so the basic play was to sell calendar spreads, even if the IV of the nearer-month(s) was higher than the vol in the outer months. 

The idea was that the position gave you positive "gamma" that you could use to trade the near-term gyrations, while at the same time gave you a bet on IV tamping down over time. That's the most common way times like these tend to ultimately resolve. This was a bit of an uglier drop than usual, so it may take longer to calm down, but odds are it's not 1987 or 2008.

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


Target Effortless Triple-Digit Gains Every Sunday Evening For Life!

This is your chance to triple your profit potential on Sunday evenings, without spending all your free time watching the market.

On Sundays, as a Weekend Plus subscriber, you’ll get up to 6 trades every Sunday, each targeting gains of 200% or more.

Start targeting gains like the ones our subscribers have seen recently, including:

213.3% GAIN on AutoNation calls
100.0% GAIN on Monster Beverage calls
100.4% GAIN on Walgreens Boots Alliance puts
100.4% GAIN on ON Semiconductor calls
257.7% GAIN on Dell calls

101.0% GAIN on Apollo Global Management calls
103.6% GAIN on JP Morgan  Chase calls
105.3% GAIN on DraftKings calls
101.3% GAIN on Airbnb calls
203.0% GAIN on Shopify calls
102.0% GAIN on Cboe Global Markets calls
100.9% GAIN on Boeing calls
102.1% GAIN on Microsoft puts
102.3% GAIN on First Solar calls
101.5% GAIN on PulteGroup calls
101.0% GAIN on Apple calls
209.4% GAIN on NXP Semiconductors calls
100.8% GAIN on Uber Technologies calls
100.4% GAIN on Academy Sports and Outdoors puts
102.2% GAIN on Trade Desk calls
100.8% GAIN on DoorDash calls
100.0% GAIN on Camping World Holdings puts
100.0% GAIN on Cboe Global Markets calls
100.2% GAIN on calls
238.5% GAIN on Oracle calls



Rainmaker Ads CGI