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Options: With Risk Premium Gone, Now What?


A deeper look into last week's volatility crossover.

Okay, as promised, let's look a bit deeper into last week's volatility crossover.

30-Day implied volatility on SPY closed at about 20 on Friday, whereas 10-Day realized volatility is over 21. As you can see on these graphs of volatility over the past six months, it's unusual for options to actually trade cheap relative to stock volatility. It's more normal to see a roughly four-point options premium. That risk premium makes sense when you consider losses on options shorts are unpredictable in timing and open-ended in quantity. It also makes sense when you consider 2008 isn't that far down the memory hole, and there was a tendency through all of 2009 to fear The Dreaded Next Leg Down that never really came.

So what of now, with that risk premium gone?

Well, there's nothing magical about HV actually surpassing IV as they measure two very different (albeit connected) things. HV tells you what just happened, IV tells you what the market expects next. But both can mislead. If the market imploded some time within the last 10 trading sessions, then 10-Day HV will "print" high until the big move leaves the calculation. Instead of SPY, let's say we looked at a stock that made a big earnings move, like Baidu (BIDU) last week. Thanks to that, HV(10) in BIDU is 60, almost double IV(30). But of course that doesn't mean options are cosmically cheap, just that the market considers the big move a one-off event.

The recent market has seen an increase in HV(10). We've seen that before over the past nine months, and generally IV has moved up in lockstep and maintained its premium. But not so much this time. But alas, IV has quirks too.

As we often note, IV measures tend to underprint ahead of weekends, and especially holidays. That's because traders face two to three days of time decay before they can trade again, so they tend to drop their bids ahead of the break to offset their decay. That doesn't always happen -- I mean, Friday, January 22, there was an incredibly ugly market and the fear of a Monday crash more than superseded any worries of a few days premium erosion. But more often than not, it just looks like a waste to pay up and hope for a big gap on Monday.

So my thought here isn't that options are cosmically cheap, rather that it's a bit of an odd confluence. Stocks have indeed gotten more volatile over the past 10 and 20 trading days, ramping up HV(10) and HV(20), but the last week got a bit churny, and with a three-day weekend on tap, no particular catalyst out there to pay up. I'd guess in the not-too-distant future,we see that premium of options over stock volume return to the normal four-point (or so) levels.

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No positions in stocks mentioned.
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