On Cheap VIX, and HV vs. IV

• Posted by Adam Warner
• on January 11th, 2011

Some comments on my response yesterday to that Slope of Hope post. First

I know what your trying to do, you are trying to stop us from buying vix so you can own them all by yourself. We are not falling for it this time either. Besides, you started out with opposite conclusion not with an open mind.

Muhahahaha….they’re onto me.

OK seriously, I did start with a conclusion in that I disagreed with the premise that options were cheap now vs. stock volatility. And I still disagree with that premise, nothing suggests otherwise.

Here’s another thought.

think there is a maths error with the slope-of-hope graph – ie it is inverted. ..ave atr/spy is ~0.008 (using a daily atr) so dividing by VIX (0.17) gives approx 0.047. The reciprocal being 21.25 – pretty much his number.  So VIX would seem to be high relative to an ATR measure of historic volatility, not low as he suggests.

I broke up SPY, ATR and VIX into three parts and simply eyeballed it. Inverting one of the numbers in the calculation would indeed explain the discrepancy, so I suspect this comment is correct.

Again though, I can’t emphasize enough that this NOT flip the whole argument and make options a sale. I mean if you knew in advance that historical volatility will sit at 5 for the next month, then yes, selling SPY options at 15 volatility sounds like a great idea. The point is though one looks backward (HV) and the other estimates forward (IV). An HV of 5 is unsustainably low, it suggest 2/3 of all days will see a .3% range or less in SPY. The HV numbers we see now look back at an incredibly non-volatile holiday stretch. Options rightly price in that we won’t  see that kind of non-action going forward.

For an extreme example of how HV and IV can diverge, consider a small binary-ish biotech ahead of news on some product. The stock itself may have tiny volatility, while options price in that the stock will double or halve once the news comes out. The attached graph shows DNDN over the past year, 20 day HV vs. 30 day IV. In late April ahead of news, IV sat at 140, HV at 30. After the news and the 30% gap, HV shot up to 110, and IV plunged to 60. The news was out. And no one would suggest options were a major buy at 60 volatility, other than a bot that would pick them up as cheap vs. historical volatility.

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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