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Collapsing Volatility

Trading options as a directional bet can be a very tricky game.  Unlike stocks and futures, you do not need to just get the direction right but you also need to get the volatility and timing right.  Back in the middle of March as the S&P was collapsing to its low of 666, one month volatility was trading in the mid 50% levels.  If you would have bought 6 month call options struck at 676 on March 9th (the low) at an implied volatility of 40%, you would have lost 36% of your option value just because volatility collapsed from 40% to 25% during the subsequent rally. Implied and realized volatility generally falls as prices rise and generally rise as prices fall which adds an extra dimension to directional trading with options.

For that reason, I do not usually recommend using options as the primary vehicle to make directional bets.  It is difficult enough to find short-term conviction in the price direction of a certain asset so why add the extra layer of complexity to your decision by creating time decay and vega exposure.  Simple stop/loss risk management decisions can effectively  protect the trader in nearly the same way as the protected nature of loss caps on long positions in puts in calls.

What I do think adds a lot of value to investment portfolios is the use of short option positions for income generation.  I focused on simple covered strategies in my previous article and I have offered evidence of how much option writing strategies outperform over time in “Volatility Selling Strategies“.  In general, the spread between implied volatility and realized volatility has historically been about 1% for the S&P 500.  That means that option buyers are usually overpaying for the risk characteristics of option contracts and providing a pretty hefty risk premium to those who are willing to consistently sell option volatility.  The real winners in the recent rally from March through September were those traders who were willing to get long the market via futures and sell implied volatility by selling option contracts (specifically puts) to those who were scared of a further financial collapse.

There was a complete collapse in volatility from the end of last year and the spread between implied and realized has gapped to historic wides

There was a complete collapse in volatility from the end of last year and the spread between implied and realized has gapped to historic wides

The key to selling options is to be a defensive player.  When realized and implied volatility kicked into the stratosphere last fall the option writer should have taken his losses (at pre-determined levels if possible) and stepped aside.  Volatility occurs in regimes, meaning that it is persistent through months of time as information is disseminated through the market.  When the rough waters start beating your boat around, it’s time to turn around and anchor in the bay until conditions calm down.

The current gap between implied volatility and actual volatility is providing very fat profits for option sellers.  The key is to remember your risk management discipline and be cautious after a 50% equity market rally.  Just because the last few months have been tame does not mean that volatility has left the ballpark.

Look below for a few ETF’s that are trading at very wide 3-month implied to realized spread levels.  There is opportunity, but be sure to stick to your loss limits.

Plenty of opportunity with very large spreads between the volatility levels that options are trading at and the actual volatility that the underlying ETF's have exhibited.

Plenty of opportunity with very large spreads between the volatility levels that options are trading at and the actual volatility that the underlying ETF's have exhibited.

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10 Responses

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  1. Chris says

    Hi,
    I am very confused by this –
    “If you would have bought 6 month call options struck at 676 on March 9th (the low) at an implied volatility of 40%, you would have lost 36% of your option value just because volatility collapsed from 40% to 25% during the subsequent rally.”
    Those calls would have been around $75 at the time and would now be $300 in the money… You would have a 300% return.

  2. SurlyTrader says

    This is a characteristic of options that is commonly ignored by many investors. You are absolutely correct in saying that the option would now be $300 in the money, but the price you paid on March 9th had an embedded value associated to an implied volatility of 40%. As the implied volatility of the option dropped, the value associated with that higher volatility went away. 36% of the original price you paid for the option went to zero because of falling volatility.

    Put another way, you would have been much better off replicating the option by buying futures (this gets complicated, so I will leave that explanation for another day). Likewise, you could have subsidized the purchase of your options by selling an out of the money put or out of the money call. By selling the extra option, you would have gained from the drop of implied volatility on the sold option and lost on the drop in implied volatility of the purchased option, thereby somewhat hedging your exposure to implied volatility.

  3. vk says

    yeah, ok to buy puts if placing a down direction bet during times of low vol. Bad idea to do the vice versa – buy calls when markets are hitting lows and vol is high – better to think value in that scenario.

  4. SurlyTrader says

    Exactly. In general you want to buy options that have an implied volatility priced in that is lower than what you expect to actually occur. Likewise, you want to sell options that have an implied volatility priced in that is higher than what you expect to occur.

    If you do want to buy calls for some reason when the market has already tanked and implied volatility is very high, then you need to find some way to subsidize that trade. You can sell options that do not interfere with your directional trade and/or you can sell futures on the vix to hedge your exposure to volatility.

  5. rogue says

    “Plenty of opportunity with very large spreads between the volatility levels that options are trading at and the actual volatility that the underlying ETF’s have exhibited.”

    How do you calculate the actual volatility that the underlying ETF’s have exhibited? Wich period is adopted?

    thanks

  6. SurlyTrader says

    Since they were 3-month implied volatilities that I was looking at, I used a 3-month trailing realized volatility which was annualized.

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