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Implied Volatility and Fat Tails

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In the world of options, Implied Volatility (IV) is one of the most important metrics.  Simply put, it reflects the market’s opinion of future prices.  Volatility rises when prices fall, and substantially so during waterfall moves like the ones we've recently experienced during February and March.  As I said a couple of days ago, I use the Implied Volatility indicator (based on the Bjerksund-Stensland option pricing model) to get a read on IV, hence the crowd's fear as expressed by the prices they're willing to pay for options.  Doing so helps me identify the point of 'maximum fear' during a cataclysmic decline, which often time implies a bottom is just around the corner.  Sure enough, the IV indicator pinpointed the end of wave 3 of C on March 20 (see below), after which 'wave 5 of C' went on to make new lows as the fear level gradually subsided (a bullish divergence, at least according to option pricing). 

Volatility doesn't just go away.  It lingers on for a quite some time.  From excessively oversold levels, the persistently high volatility often produces outsized rallies that are as dramatic as the preceding selloffs.  That's why volatility is often cited to be the trader's best friend.  High volatility also implies high option prices (high premium) and vice versa;  During periods of high volatility, the price of an option is substantially higher than the price of a comparable option during low-volatility periods.  Hence, buying a call or a put option as a bet on a forthcoming rally or a sell-off would be an expensive proposition, especially if the market fails to move in your desired direction soon enough for the option premium to rise (time decay = premium erosion).  This is almost like trying to make your way from point A to point B by halving the remaining distance with every forward move you make.  You'll simply never get there.  Instead, selling premium is often times the better strategy (to be expanded upon in a video), hence the reason why I'm an avid $SPY premium seller as often as three times a week. 

Moreover, IV doesn't imply direction.  If IV is at, say, 50% when the S&P 500 is trading at 2400, it's simply reflecting the market's current opinion of future prices, which is either 50% higher or lower one year from now (everything is annualized in the world of option pricing models).  You simply don't know, though a sound technical analysis should help put the odds in your favor.  In this example, the range would be 1200 to 3600 within a year.  But remember, this is just a metric derived from a statistical pricing model that probably has very little to do with a future that no one can possibly predict.  Another statistical metric to be mindful of is the standard deviation.  One standard deviation encompasses 68% of all possible outcomes (Bell curve).  One standard deviation implies a 68% chance our S&P 500 will remain in the implied range of 1200-3600 during the next year.  That's what IV is all about.

Well, your first impression might be that this is no rocket science;   Any person with half a brain would probably be willing to make that safe bet.  But imagine how tight the range was when the IV was 1% just three months ago!  At 1%, the range was roughly 35 points in one direction or the other.  In other words, 68% of all the potential price outcomes would have fallen within -35 to + 35 points in reaction to any good or bad event.  Hence, the odds of a price outcome outside this 70-point range would have had a probability of 32% or less.  In retrospect, what we ended up with in March was the tail end of the probability curve.  For example, on February 21, the $SPY 300-strike put option expiring March 20 was worth $63/contract, and the 250-strike was a measly $7.  They were priced for a Utopian world!  Meanwhile, the financial media pundits were combatively staring down that poor camera lens, proclaiming the S&P 500 is inevitably heading to 3,800.  But by the time the $SPY closed at 228.80 on March 20, those two put contracts were suddenly worth $7,042 and $2,100, respectively.  That's what a Black Swan (a fat-tail event) is all about, and in the financial markets, it's almost always preceded by extreme levels of complacency.  Most people don't understand the world we live in, and that's where the opportunities often lie.  

In a few short years, when the supercycle's fifth wave finally ends, we'll hopefully remember this lesson.  In all honesty, I was eagerly waiting for this event, but I ended up missing the entry point simply because I wanted to see the S&P 500 rally another 1-2% to 3440.  As it turned out, my beautiful Utopian chart demanded more symmetry before declaring the top of the bull market (the deficiency of an analytical mind).

 

Using Implied Volatility to pinpoint max fear

 

Payoff chart #1 ($SPY 300-strike put)

 

Payoff chart #1 ($SPY 250-strike put)

 

Trade vigilantly,

 

Peter Ghostine (@peterghostine)


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