Here’s a chart I sent out to clients last night as part of our weekly update. It tracks the ratio of three-month SPX implied volatility as measured by VXV to the trailing 3m historical volatility.
SPX 3-month volatility risk premium. Source: Yahoo!, Condor Options
What the chart shows is that three-month options are priced at more than 1.4 times the value of the actual rate of change in stocks over the last quarter. Options are usually a bit overpriced, but this reading is on the high side, suggesting that traders have been pricing in risk from bad fiscal cliff outcomes for some time.
Instead of trading at an 11% annualized rate of change as they have over the last quarter, stocks would have to become volatile to the tune of 16% to justify current options prices. That translates to a daily change of 1% or more about one third of the time – far more dramatic than the price action we’ve been seeing. Of course, everything could change if fiscal cliff politics don’t work out. But right now, the most likely outcome is still that hedgers and option buyers will find out that they’ve overpaid for protection. In other words, this week’s pop in implied volatility could easily turn out to be an early holiday gift to volatility shorts.