The two watchwords over the past month have been “unprecedented” and “volatility,” often with both used together. And indeed, volatility did, in fact, hit both unprecedented levels. But, the questions now are whether it peaked and what can we expect going forward?
To answer those questions, we first need to set the table in terms of what we mean by volatility and where it has been. The first item to understand is that the VIX is a statistic which uses a formula of combining a variety of strikes and expiration dates to measure the constant maturity 30-day implied volatility given SPX options or the “SPDR 500 (SPY)” proxy.
The second item is to understand that implied volatility gauges what the options market expects in terms of price to happen in the future while historical or realized volatility is a measure of what price actually did over a given time period. The third item to understand is that both IV and HV tend to be mean-reverting. Meaning over time these measures will tend to track each other.
Under normal circumstances, implied volatility will be higher than historical volatility because most people have more confidence about what will happen tomorrow or next week than what might happen three months or a year from now. But the recent price action — and yes, unprecedented volatility — have caused HV to trade and a large premium to IV as the spread continues to persist.
Over the past 21 trading days, SPY hit a high of 102% which reflects the fact the market was moving an average of 4.9% each day. The VIX peaked at 85%, meaning options were pricing in a 4.2% daily move. This seems to suggest that while there are no real boundaries for how high or low volatility can go, and these are relative terms. That said, we know VIX can’t go to zero (unless the market were to close) and that in reality there seems to be a floor around the 10% level. In this latest surge in volatility, we may have found the upper bound. That is, as described above, even as HV surged above 100% the VIX simply would not go any higher.
Here is what that chart looks like as of yesterday’s close:
So what does this chart show?
- 30 (actual) day realized volatility is 93.7%
- Implied volatility is 61.0%
- The spread between implied volatility and 30 (actual) day realized volatility is –32.72 points.
- This ranks at .15 percentile on data going back to around 2004, indicating that this spread has only been more negative on .15% of trading days during this time period.
Another sign that volatility might have peaked is by looking at the VIX term structure. Again, under normal circumstances later dated options carry higher implied volatility, which is called contango. But when times become uncertain and volatility spikes the near-term options trade higher, or in backwardation.
As you can see below during the teeth of the sell-off on March 18 the backwardation was quite steep with front-month options trading nearly 30 points higher than those 100-120 days out. The levels have now not only come lower in absolute terms but the structure has also flattened.
So, is implied volatility expensive or cheap? On an absolute basis, it is very expensive, the only time at higher for a sustained period was during the financial crisis. But on a relative basis, it can be considered somewhat cheap.
A good analogy would be if someone took a hammer to your hand. It would swell up beyond all recognition and then slowly begin to return to normal. But it will be sensitive and any bump or knock will be painful and cause the swelling to return and delay the healing process.
Likewise, we may have seen the peak in volatility but the elevated levels will likely persist for the foreseeable future.
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SPY shares were trading at $259.87 per share on Tuesday afternoon, down $1.78 (-0.68%). Year-to-date, SPY has declined -18.79%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Steve Smith
Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...
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