It’s absolutely nuts that implied volatility has exploded higher on such a small decline from recent highs. In the attached video, I explain this week’s selloff by looking at term structure changes in TLT, SPX, and IYR. Note in particular the divergence between IYR and the S&P 500.
Flatter term structure in option implied vol is one of the most meaningful indicators of changes in sentiment, because especially for longer-dated comparisons, it takes a lot more to move the needle. These comparisons filter out a lot of noise and tell us more about market sentiment than can be understood by watching one data point (e.g. VIX) alone.
I also show a table of 3 month / 1 year implied vol term slopes for major ETFs as of yesterday’s close. Values of about 0.9 to 0.97 are typical (depending on the asset) for a normal, bullish market. As you can see, some signs of stress are showing up now. This has some important implications for traders:
- If you’re looking to hedge against a further market breakdown, buy premium where it is still cheap relative to the rest of the market. FXI or DIA options are a better value here.
- Once the market finds a bottom, short volatility trades will be much more attractive than outright longs. I would even start fading the overreaction now.
Of the major U.S. equity indexes, the flattest term structure can be found in IWM. Traders can buy a time spread here to profit from a return to normalcy in volatility.