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Will Volatility Spike?

When trading options, it is always useful to take a step back and assess your overall view on volatility levels.  If you believe that volatility is low given market conditions, then you should probably slant towards being an option buyer.  If you believe that volatility is too high, then you should overweight option selling.  This might seem obvious, but many times traders get too caught up in the trades being made or whether he/she feels that the markets will continue to rally or tank.  As I have stated many times, the very nice characteristic of volatility is that it is generally mean reverting.  This means that when volatility gets high, it will usually revert to its longer term mean and vice versa.

In order to make mean reversion useful, you must define the time period that you will be looking at in order to establish a baseline for volatility.  From my perspective, volatility experiences regime shifts.  If you look at the time period from mid 2007 through today, volatility has been elevated compared to the time period between 2003 and 2006:

Before 2007 volatility was muted, but since then volatility has been elevated mostly above 20%

If I only look at the last three years then I can make general observations about this period of elevated volatility across different tenors of options.  In this study, I will only look at 1 month and 3 month implied volatilities for the S&P 500, the Nasdaq, and the Russell.  If I examine the daily implied volatilities of this subset, then I can see what the average implied volatilities were, as well as decile rankings of implied volatility with a visualization through a box-plot:

Implied Volatilities across the board are at or near three year lows

Before shying away from this chart, let me explain what it means.  If you concentrate on the first section, SPX 1 month, then you are looking at the implied volatility distribution of the S&P 500 1-month, at-the-money options from March 2007 through March 2010.  The minimum recorded value was 10.11% while the maximum recorded value was 74.49%.  What provides a better feeling are the 10% and 90% deciles which are marked by the outer border of the white box.  This shows that the current 1-month implied volatility of 16.46% (red diamond) is not far from lowest 10th decile (13.94%) of the distribution while being a considerable distance from the 90th decile (41%).

Does this mean that I will buy all of the options I can get my hands on?  No.  What this means is that from the implied volatility distribution of the last 3 years, volatility looks relatively cheap unless you believe we will be re-entering a low volatility period.  With the recent cliff-diving that the British Pound and Euro have done, I would not bet on it.  It also highlights the relative value of the different index options.  Nasdaq and Russell implied volatilities look cheaper relative to the S&P 500.  This differential could be used to create a cross-asset pairs trade or to find the cheapest place to express a view.

Posted in Derivatives, Markets, Trading Ideas.

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