## Volatility Tracker: Shorting the Conventional Wisdom

Sun, Aug 16, 2009 | Jared Woodard

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Volatility Tracker for the week of August 17, 2009

Conventionally, equity prices and implied volatility are inversely correlated, meaning that traders who expect a price decline should be net buyers of options. But as long as the ratio of lagged implied and realized volatility remains this high, [5,6] it makes sense to be a net seller of equity index options, even alongside the expectation of a modest price decline. Regarding index prices, I would only mention that an “overbought” condition can be resolved by time just as easily as by price: a week or two of sideways trading would negate most bearish signals just as easily as if equities retraced some of their recent gains. [4] Volatility futures barely twitched this week, [7] but the persistently high implied correlation warrants further study. [10]

Two important points about the implied volatility landscape bubbled up into the mainstream financial press this week. One commentator noted that at current levels of implied volatility, options are pricing in daily moves in equities over over 1.5% (68% of the time). We’re clearly not seeing that kind of day-to-day action, so it is reasonable to conclude that implied volatility has been overestimating realized volatility for some weeks now. Of course, that’s not news to readers of this report, as we continually track the Implied Daily Move (below, this page) as well as the ratio of implied and realized volatility across several assets. [6, 13, 16] Secondly, Barron’s picked up on the notion – discussed here and at several other quality blogs back in July – that the upward-sloping term structure in VIX futures might not be the grand omen that some (Bloomberg) have taken it to be.

The inability of crude oil prices to break meaningfully above $72 has many traders looking for more downside. [15] Whatever your directional bias, it is notable that options on crude oil are no longer “expensive” for the first time since March – meaning that implied volatility has recently begun to accurately price or even underestimate realized volatility. If the trend measured at [16] continues, traders may want to express directional views via outright option purchases, rather than by favoring net sales.

1. Comment. Highlights items of note in the data below along with our short-term volatility bias and any trading theses. The Expected Daily Move table displays the de-annualized price and percentage change in each underlying asset as implied by its volatility index, within one standard deviation. The Forward Bias table displays my bias for the movement of the price and implied volatility of several assets for the coming week.

2. Weekly Change. Tracks the weekly percentage change in the assets listed and in their implied volatility indexes.

3. Implied Volatility Indexes. A one year chart of the implied volatility indexes for the S&P 500, gold, oil, and USD/EUR. Indexes for the Nasdaq 100 and Russell 2000 are omitted because of their tight correlation with VIX.

4. S&P 500 Price and Bollinger Bands. Tracks daily closing prices in SPX with an overlay of one and two standard deviation 50-day bands.

5. S&P 500 Implied and Realized Volatility. Tracks the 21-, 60-, and 90-day realized (or “historical”) volatility of the index and the21-day lagged CBOE Implied Volatility Index (”VIX”). Realized volatility is displayed as the annualized standard deviation of lognormal returns over the period specified, and may be thought of as a backward-looking measurement of price behavior. Implied volatility is the annualized standard deviation of returns implied by option prices, and may be thought of as a forward-looking measurement of expected price behavior.

6. S&P 500 Implied/Realized Volatility Ratio. Tracks the ratio of 21-day lagged implied volatility (IV) to 21-day realized volatility (RV). This ratio asks how well IV from one month ago predicted the RV over the next 21 trading days (roughly, 30 calendar days). When IV correctly anticipates RV over the period, the ratio will hover near 1; we regard the area near 0.9 –1.2 as normal, given the persistence of a volatility risk premium in equity market derivatives. A ratio less (greater) than 1 indicates that the price behavior of the underlying asset was more (less) volatile than anticipated.

7. Volatility Futures Term Structure. Tracks the Friday closing prices of the Volatility Futures complex (VIX, VXD, RVX) for the two weeks prior, along with the spot levels for reference.

8. VIX Premium Ratio. Tracks the ratio of rolling three-month (VXV) to one-month (VIX) implied volatility. Periods in which one-month readings persist at an extreme premium or discount to three-month levels have tended to coincide with major market moves.

9.S&P 500 Daily Return Distribution (3 month). Histogram plotting the frequency of daily percentage returns over the prior 63 trading days.

10. Implied Correlation Index. Reflects the market-capitalization weighted average correlation of the 50 largest components of the S&P 500.

11. Gold Price and Bollinger Bands. Tracks daily closing prices in GLD with an overlay of one and two standard deviation 50-day bands.

12. Gold Implied and Realized Volatility. Tracks the 21-, 60-, and 90-day realized (or “historical”) volatility of the ETF and the 21-day lagged CBOE Gold Volatility Index (”GVZ”).

13. Gold Implied/Realized Volatility Ratio. See #6 above; given the novelty of the VIX-style gold volatility index (GVZ) and the characteristics of the underlying, we do not yet have a range we regard as normal.

14.Gold Daily Return Distribution (3 month). See #9 above.

15-18. Oil charts correspond to 11-14 above.

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August 16th, 2009 at 10:24 pm

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