Macro Wrap – $SPX Options Too Cheap

by Enis February 4, 2013 7:50 am • Commentary

One of the first themes of options trading that I learned on the trading desk was that the best predictor of future volatility is recent realized volatility, all else equal.  Best predictor does not mean good predictor.  It simply means, of all the alternatives, recent realized volatility is the best starting point to use when considering, are options cheap or expensive at this moment?

The stipulation is “all else equal” since a known future event (such as an earnings report) will of course change the market’s prediction of future volatility.  But in the absence of known future events, recent realized volatility is the first guide to assess where I think future volatility in an asset is going to be.

With that in mind, SPX index options look too cheap to me.  This is a chart of 30 day realized (in black) vs. 30 day implied (blue) volatility of the SPX index over the last 8 years:

SPX 30 day implied vs. realized, courtesy of Bloomberg
SPX 30 day implied vs. realized, courtesy of Bloomberg


I’ve drawn a red line at the 10 level, which is near the lows of the past 10 years.  We are currently in a low volatility regime, as it’s rare to see realized or implied volatility of 10 over the past 8 years.  What’s noticeable however, is that anytime the blue line (implied volatility) has touched 10 or lower (which occurred many times in 2005 and 2006), it was almost always in the context of the black line (realized volatility) being below 10.  In other words, implied volatility almost never got as low as 10 without realized volatility already being below 10.

Today’s situation is one where implied volatility and recent realized volatility are both almost identical, around 11.  I have a hard time seeing SPX 30 day options prices (as represented by implied volatility) moving much lower from here when realized volatility is still above 10.  Moreover, the SPX is at 5 year highs.  That’s important because there is less of a price context for current traders, which can cause increased volatility going forward.

Finally, the chart above shows that most of the time, the blue line is priced slightly above the black line.  That’s because options are usually priced at a slight premium to recent realized volatility since they offer asymmetric upside vs. limited downside.  With implied volatility at 11, that asymmetry is even more pronounced.  But realized volatility is also at 11, so no current premium exists.  Add it all up, and you’re currently getting the asymmetric reward too cheaply by buying SPX options.

Markets Overnight:

  • Quiet overnight session in Asia, with Jpaan higher and other markets mixed.
  • Europe down around 1%, led by Spain and Italy, as sovereign bond yields move higher.  Spanish Prime Minister Rajoy is dogged by corruption charges, and Berlusconi (markets rooting for Monti) is gaining in polls ahead of Italian elections.
  • SPX futures down 0.4%, dragged lower by Europe.
  • Dollar stronger vs. Euro, otherwise mixed.  Treasury bonds close to flat.
  • Commodities broadly lower, led by oil down 1%.
  • Economic data light this week.  ISM Non-Manufacturing data tomorrow the only release of note.