Macro Wrap – Volatility Rises at Turning Points?

by Enis April 17, 2013 7:46 am • Commentary

I’ve clearly gotten more bearish in the past week.  Putting my own directional bias aside though, from a pure volatility standpoint, this is the best time that I’ve seen over the past year to replace your bull or bear bets with long options positions

Trade structure is a crucial part of options trading.  Right now, realized volatility is rapidly picking up across the market, but implied volatility has not caught up yet.  Here is the chart of 30 day IV (blue) vs. 10 day RV (black) in the SPX index:

10 day realized vol in SPX (black) vs. 30 day implied vol, Courtesy of Bloomberg
10 day realized vol in SPX (black) vs. 30 day implied vol, Courtesy of Bloomberg

I’ve circled in red each instance in the past year where 10 day realized volatility jumped above 15 (which is not even that high – that measure was above 15 for most of 2011, for example).  Now compare where the 30 day implied volatility (blue line) was at each of those circled instances.  In each instance, it rose to at least 15 as well, as realized volatility caused option buyers to price in higher future volatility.

But in the current instance, implied volatility has hardly risen.  Since options traders have been burned for the past year buying options at the first sign of increased realized volatility, they’re treating the current situation as The Boy Who Cried Wolf scenario.  They don’t want to buy options anymore.

As I showed yesterday, the instability in the VIX is a new phenomenon, not seen over the past year.  And the incredible volatility in commodities should not be ignored either.  Dislocations in one major asset class generally leads to at least reduced risk taking (and thus reduced liquidity, and higher volatility) among market players in other asset classes.

Even for those who are not short-term traders, current option pricing offers stellar risk/reward to buy longer-dated put option protection on the SPX index (and hence, on most single names as well).  Particularly since warning signs from global markets, other asset classes, and market internals have continued to stack up.  This time, there might actually be a wolf lurking in the village.