Are You Being Fooled By Option Implied Volatility?

Several clients mentioned the sizable decline in implied volatility (IV) yesterday and characterized current levels of IV as too low to sell. I think I can sympathize with that intuition. After all, we’re closing in on the lowest levels seen since May, and 18% IV won’t strike most volatility traders as an obvious selling opportunity. To get a snapshot of the current level, let’s take the average of the eight nearest-to-the-money strikes in December SPX options, as shown below (click to enlarge):

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The average of those 16 options gives us an implied volatility of 17.69%. That’s a little lower than the current VXO (18.86%) and VIX (19.56%), but those include November options, and, in the case of VIX, out-of-the-money options with higher volatility skews. But again, 18% IV sounds eminently reasonable.

But let’s look a little deeper. The chart below shows the recent history of VXO along with the historical volatility of SPX as measured using closing prices only and the Yang-Zhang estimate. (I discussed the latter in the June 2010 issue of Expiring Monthly).

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One of the principal advantages of the Yang-Zhang estimate is that it incorporates opening, high, and low prices for each period in addition to closing prices, which means you’ll see a higher reading on days when there are significant intraday swings, even if the closing price isn’t far from the day before. I’m inclined to regard the Yang-Zhang estimate as more reliable here. If you watched or traded the market around yesterday’s FOMC announcement, it certainly didn’t feel like an 8% annualized volatility sort of environment.

But whichever estimate you use, it’s clear that the actual market volatility has been lower than contemporaneous IV estimates for many weeks. A five-point difference between recent historical and current implied volatilities isn’t that unusual, but it’s also not something I would necessarily characterize as “Too low to sell.” And I certainly wouldn’t be anxious to buy any straddles here without some evidence that realized volatility was starting to pick up. Despite the post-FOMC decline, implied volatility is higher here than it might seem.