Still Not Time to Back Up the Volatility Truck

• Posted by Adam Warner
• on October 21st, 2009

Now with the VIX at generational lows (if your definition of a generation is 14 month’s), the temptation is of course to do long volatility plays.

But does that make sense?

First, let’s be clear, in 2009 there are many ways to go long volatility. The most direct of course is to buy the VIX. You can do that by purchasing VIX futures, VIX calls, or the VXX ETF, which tracks a perpetual 30 day VIX future. Always remember that the VIX you buy is not the actual VIX on the board. October expires on the open today, so your near month is Nov. And they trade with a 24 full. So you’re buying at over a 3 point premium. Since VXX is a 30 day duration, right here right now it’s pretty much equal to owning the Nov. future. So while I suspect the VIX is near a short term bottom, not so sure I would want to own it if I need 3 points rally just to basically break even.

So that leaves us with actual options, say Novembers in SPX or SPY. ATM’s are in the teens again, so why not lock in “cheap” volatility that way?

Well, there’s this pesky fact called “realized volatility”. That’s the actual volatility of the underlying. We don’t know what it will do in the next 30 days, but we can see how it has done recently, and it’s not pretty. Above we see 10 Day HV in the SPY over the past 6 month’s, and as you can see, it’s near 10 again. It’s noisy, but if you look at the last 2 month’s or so, it hovers around 15-16. Options almost always have a modest premium to HV, so if you expect that to continue, options are pretty fair right now. If 10 is the new 15 however, we’re back to the same overpricing, just at lower levels.

Personally, I’d rather miss THE bottom in volatility and pay more on an upswing. Every day you own an option that’s overpriced relative to the volatility realized in the underlying, you theoretically lose money. Since I’m not Goldman Kreskin, I don’t know when exactly volatility will price correctly, my best guess is if it starts trending the other way, then maybe it’s time to take a look. That time is not upon us just yet.

Now these are just general volatility thoughts. If you have a gain and want to protect them with puts (or replace stock with calls), I certainly do not want to dissuade anyone.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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