After arguably the Least Volatile Year ever of trading in 2017, calendar year 2018 has delivered a lot more drama.
Minus a sudden agreement that miraculously ends the ongoing trade dispute between the United States and China, it's hard to envision markets becoming complacent during the last month of the year, either.
But while markets have been intriguing during 2018, a recent episode of Options Jive helps illustrate that some things never change - especially in terms of the overstatement of implied volatility relative to realized volatility.
As a reminder, Implied volatility represents the market's expectation for movement in an underlying security, whereas realized volatility (also referred to as historical volatility) represents how much an underlying actually moved.
Historical data has shown quite clearly that implied volatility consistently is richer than realized volatility, which is the primary reason that short premium strategies outperform long premium strategies over time, on average.
Given that options represent a type of insurance on the assets that underlie them, this seems rational. Protection has a price.
Of course, there will be instances in which that paradigm doesn't hold. Corporate buyouts and bankruptcies can catalyze big moves in either direction (for single stocks especially), which can in turn pressure short options. That's why at tastytrade we prefer to diversify our portfolios with a multitude of smaller exposures that are well diversified, as opposed to concentrating risk in any single position.
Likewise, we also prefer to trade options in indices or ETFs which are much less likely to suffer "catastrophic" moves.
On that note, let's review the relative overstatement of implied volatility thus far in 2018 using data from the aforementioned episode of Options Jive. On the show, the hosts walk through the net difference between implied volatility and realized volatility for some of the largest asset classes, including:
US stock indices (SPY, QQQ, DIA, IWM)
International stock indices (EEM, FXI, EWZ)
Single stocks (AAPL, AMZN, GOOG, GS, IBM)
Commodities (GLD, SLV, USO)
Currencies (FXE, FXB, FXY)
Because they are arguably the most pertinent for volatility traders, let's start off with US stock indices. As you can see in the graphic below, implied volatility was consistently richer than realized volatility for all four of the major indices:
What's somewhat surprising in the above data is that IWM was the leader in terms of net overstatement of implied volatility. The IWM is the ETF for the Russell 2000, which is made up of small-cap stocks.
Because they have more limited financial resources and reduced scope in terms of business operations, small-cap stocks are usually more sensitive to movement in the the broader markets. This is especially true when comparing them to big-cap (or mega-cap) organizations - small-cap companies just can't withstand economic downturns, or other headwinds, as well as their larger counterparts.
While we hope you'll review the complete episode of Options Jive for the complete picture on implied volatility vs. realized volatility in 2018, we do want to highlight a couple more important data points from the show.
In terms of international indices, it's interesting to note that EWZ (the ETF for Brazil) showed the highest overstatement in implied volatility of the three included in the study. Less surprising may be the fact that FXI showed the least overstatement of those examined - Chinese equities have been moving a lot, and it appears the market has priced the options to reflect that.
It is important to state that even with all the volatility in Chinese equities, implied volatility still did outpace realized volatility.
Looking back on the year, one good question to ask yourself is which niches of the market you think that realized volatility was higher than implied volatility?
The answer to that question, and one that you may have thought of, highlights the biggest outlier from the study - crude oil. The ETF analyzed as a proxy for crude was USO, and data in USO showed that implied volatility was on average 28.3% throughout 2018, while realized volatility was significantly higher at 30.8%.
Of all 18 symbols examined in the study, USO was the only one that revealed a higher level of actual volatility as compared to implied volatility. The only other symbol that almost met this criteria was GOOG, which showed almost an equal level of realized vs. implied volatility.
If you want to review additional data relating to volatility and the 2018 trading year, we also recommend watching a recent installment of Market Measures. The focus of this show is movement in the VIX during 2018 as compared to past years.
Should you have any questions relating to the balance of the 2018 trading year, or the start of 2019, don’t hesitate to leave a message in the space below, or contact us directly at @tastytrade on Twitter or by email at firstname.lastname@example.org at your convenience.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.